AAT
Level 4
Diploma in Professional
Accounting
Credit and Debt
Management
Course Book
For assessments from
September 2022
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First edition 2021
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ISBN 9781 5097 4340 7
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Contents
Page
Introduction to the course
Skills bank
iv
viii
1
2
3
4
5
1
15
45
71
87
Managing the granting of credit
Granting credit to customers
Legislation and credit control
Methods of credit control
Managing the supply of credit
Activity answers
Test your learning: answers
Glossary of terms
Bibliography
Index
111
125
133
135
137
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iii
Introduction to the course
Syllabus overview
This unit provides an understanding and application of the principles of effective credit control
systems, including appropriate debt management systems. Organisations will usually offer credit
terms to its customers, which could lead to financial difficulties if customers pay late or do not
pay at all. It is therefore important to determine that potential credit customers can honour any
credit terms agreed.
This unit will consider the techniques that can be used to assess credit risks in line with policies,
relevant legislation and ethical principles. Equally, once the credit decision has been approved, it
will be important to ensure that any debts due from the customer are paid within the terms
agreed. Students will also consider what techniques are used to enable the collection of any
overdue debts, following organisational policies, legal procedures and methods for collecting
debts.
Knowledge and use of performance measures relating to liquidity, profitability and gearing are
fundamental to this unit. Students will also develop their understanding of liquidity management,
bankruptcies and insolvencies, as well as the mechanisms of invoice discounting, factoring and
credit insurance.
Test specification for this unit assessment
Assessment method
Marking type
Computer-based assessment
Duration of assessment
Partially computer/partially
human marked
Learning outcomes
2 hours
Weighting
1
Understand relevant legislation and contract law that impacts the
credit control environment
15%
2
Understand how information is used to assess credit risk and grant
credit in compliance with organisational policies and procedures
45%
3
Understand the organisation's credit control process for managing and
collecting debts
25%
4
Understand different techniques available to collect debts
15%
Total
100%
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Assessment structure
2 hours duration
Competency is 70%
*Note that this is only a guideline as to what might come up. The format and content of each task
may vary from what we have listed below.
Your assessment will consist of 6 tasks
Task
1
Expected content
Statute law, contract law and ethical
principles.
Max
marks
Chapter ref
15
Legislation and
credit control
24
Granting credit
to customers
Study
complete
The method of assessment can include
drag and drop, gapfill and entering
ticks.
Coverage can include, but not limited
to: the components of a valid contract
including how a contract can cease to
be valid and the Consumer Rights Act.
The Data Protection Act can also be
tested here, including principles of good
data practice. Calculations can include
interest payable from late payment of
commercial debts.
2
Credit rating sources and calculation
and analysis of performance indicators
leading to a credit assessment
decision.
Students should anticipate having at
least two years’ worth of financial
statements to support a credit facility
application from a new or existing
customer. The indicators to calculate
will typically fall into three categories:
profitability, liquidity and gearing.
Examples can include:










Gross profit margin
Operating profit margin
Return on capital employed
Current and quick ratios
Inventory holding period
Receivables collection period
Payables payment period
Working capital cycle
Gearing ratio
Interest cover
Once the performance indicators have
been calculated, it is likely a credit
rating scoring system will need to be
applied to reach an assessment
decision recommendation.
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Task
Expected content
3
Credit rating sources and the analysis
of performance indicators leading to a
credit assessment decision (written).
Max
marks
Chapter ref
25
Managing the
granting of credit
& Granting credit
to customers
12
Managing the
granting of
credit, Methods
of credit control &
Managing the
supply of credit
12
Legislation and
credit control,
Methods of credit
control &
Managing the
supply of credit
It is likely that this task will require a
written answer and students may
expect the task to split into two or three
parts. The first part may require a
discussion of a particular area of credit
management or control.
Other parts of Task 3 could require an
analysis of one or more sets of
customer financial statements in
support of a credit application.
Alternatively, performance indicators
may be supplied instead of financial
statements. Students need to be
prepared to analyse results, provide
supporting explanations and reach a
conclusion on whether credit can be
given or extended.
4
Management of debts and liquidity.
The method of assessment can include
drag and drop, gapfill and entering
ticks.
The following techniques could be
tested in this task:
Calculation of discount costs including
the simple and compound interest
methods
Aspects of liquidity management
Calculation of expected cash flows
from customers
Credit management techniques, for
example, credit insurance.
5
Techniques available to collect debts.
The method of assessment can include
drag and drop, gapfill and entering
ticks.
The following techniques could be
tested in this task:
Identification of appropriate courts
Specific clauses contained in contracts
Techniques to manage credit, for
example, use of factoring agencies
Bankruptcy and insolvency
Remedies for breach of contract
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Study
complete
Task
Expected content
6
Management of accounts receivables
balances (written/other question
types).
Max
marks
12
Chapter ref
Study
complete
Managing the
supply of credit
This task will require students to take
into account all available information
and make a written response outlining
the appropriate actions to take
appropriate to the individual customer’s
circumstances. Calculations of
expected receipts from customers may
also be required.
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Skills bank
Our experience of preparing students for this type of assessment suggests that to obtain
competency, you will need to develop a number of key skills.
What do I need to know to do well in the assessment?
This unit is one of the optional Level 4 units. The purpose of the unit is to cover the principles of
effective credit control in an organisation.
To be successful in the assessment you need to:

Analyse legislation and contract law and its impact on credit management. In addition, be
able to assess credit risk and grant credit in compliance with policies and procedures.

Evaluate credit control policies and procedures and various methods of debt collection.
Additionally, to be able to present advice and recommendations to management.
Assumed knowledge
Credit and Debt Management is an optional unit and several concepts and topics may be new to
you. Some areas were covered briefly in previous units of the AAT qualification and these include:



The legal environment
Aged receivable reports
Irrecoverable and allowances for doubtful receivables
Assessment style
In the assessment you will complete tasks by:
1
Entering narrative by selecting from drop down menus of narrative options known as
picklists
2
Using drag and drop menus to enter narrative
3
Typing in numbers, known as gapfill entry
4
Entering ticks
5
Entering dates by selecting from a calendar
6
Written answers
You must familiarise yourself with the style of the online questions and the AAT software before
taking the assessment. As part of your revision, login to the AAT website and attempt their online
practice assessments.
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Answering written questions
In your assessment there will be written questions for you to answer. These tasks will include the
calculation and analysis of key performance indicators such as financial ratios supplied by
existing and potential new customers. You should also expect written questions on the actions to
take when customers are late in settling outstanding amounts on their account.
The main verbs used for these type of question requirements are as follows, along with their
meaning:
Identify – Analyse and select for presentation
Explain – Set out in detail the meaning of
Discuss – By argument, discuss the pros and cons
Analysing the scenario
Before answering the question set, you need to carefully review the scenario given in order to
consider what questions need to be answered, and what needs to be discussed. A simple
framework that could be used to answer the question is as follows:




Point – make the point
Evidence – use information from the scenario as evidence
Explain – explain why the evidence links to the point
Recommend – provide guidance on how to proceed
For example, if an assessment task asked you to explain the current ratio, you could answer as
follows:
1
Point – the current ratio shows the relationship between current assets and current
liabilities
2
Evidence – in this case the potential new customer has significantly higher current liabilities
compared to current assets in the financial statements they have submitted for analysis
3
Explain – which means that/the consequences are…
Recommendations are normally also required, and are to provide guidance on how to proceed:
Recommendation – therefore we should decline this customer’s credit application
This approach provides a formula or framework that can be followed to answer written questions:
The current ratio shows the (Point)….in this case the potential new customer (Evidence)….which
means this customer (Explain)….therefore we should/should not….(Recommendation).
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Introduction to the assessment
The question practice you do will prepare you for the format of tasks you will see in the Credit
and Debt Management assessment. It is also useful to familiarise yourself with the introductory
information you may be given at the start of the assessment. For example:
You have 2 hours to complete this assessment.
The assessment contains 6 tasks and you should attempt to complete every task.
Each task is independent. You will not need to refer to your answers to previous tasks.
Read every task carefully to make sure you understand what is required.
Where the date is relevant, it is given in the task data.
Both minus signs and brackets can be used to indicate negative numbers unless task instructions
say otherwise.
You must use a full stop to indicate a decimal point. For example, write 100.57 not 100,57 OR 100
57.
You may use a comma to indicate a number in the thousands, but you don't have to. For
example, 10000 and 10,000 are both acceptable.
1
As you revise, use the BPP Passcards to consolidate your knowledge. They are a pocketsized revision tool, perfect for packing in that last-minute revision.
2
Attempt as many tasks as possible in the Question Bank. There are plenty of assessmentstyle tasks which are excellent preparation for the real assessment.
3
Always check through your own answers as you will in the real assessment, before looking
at the solutions in the back of the Question Bank.
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Key to icons
Key term
A key definition which is important to be aware of for the
assessment
Formula to learn
A formula you will need to learn as it will not be provided
in the assessment
Formula provided
A formula which is provided within the assessment and
generally available as a pop-up on screen
Activity
An example which allows you to apply your knowledge
to the technique covered in the Course Book. The
solution is provided at the end of the chapter
Illustration
A worked example which can be used to review and see
how an assessment question could be answered
Assessment focus point
A high priority point for the assessment
Open book reference
Where use of an open book will be allowed for the
assessment
Real life examples
A practical real life scenario
KEY
TERM
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AAT qualifications
The material in this book may support the following AAT qualifications:
AAT Level 4 Diploma in Professional Accounting and AAT Diploma in Accounting at SCQF Level 7
Supplements
From time to time, we may need to publish supplementary materials to one of our titles. This can
be for a variety of reasons, from a small change in the AAT unit guidance to new legislation
coming into effect between editions.
You should check our supplements page regularly for anything that may affect your learning
materials. All supplements are available free of charge on the supplements page on our website
at:
www.bpp.com/learning-media/about/students
Improving material and removing errors
There is a constant need to update and enhance our study materials in line with both regulatory
changes and new insights into the assessments.
From our team of authors, BPP appoints a subject expert to update and improve these materials
for each new edition.
Their updated draft is subsequently technically checked by another author and from time to time,
non-technically checked by a proof reader.
We are very keen to remove as many numerical errors and narrative typos as we can but given
the volume of detailed information being changed in a short space of time, we know that a few
errors will sometimes get through our net.
We apologise in advance for any inconvenience that an error might cause. We continue to look
for new ways to improve these study materials and would welcome your suggestions. If you have
any comments about this book, please use the review form at the back.
These learning materials are based on the qualification specification released by the AAT in
September 2021.
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Managing the
granting of credit
Syllabus learning outcomes/objectives
2.1
Sources of credit status and assessment methods used in granting credit
Learners need to understand:

The range of internal and external sources of information:
–
External sources: credit agencies, trade and bank references, published financial
statements, management accounts, publications and credit circles
–
Internal sources: records, conversations, emails, staff visits, calculation of
performance indicators, credit scoring of performance indicators

The usefulness and appropriateness of different types of information
Learners need to be able to:

2.3
Complete a credit scoring of performance indicators
Reasons for granting, refusing, amending or extending credit
Learners need to understand:


3.1
Organisational policies and procedures specific to changes to credit terms
How to assess and communicate changes to credit terms
Methods for the management of debts
Learners need to understand:


The characteristics of an effective credit control system
Organisational policies and procedures specific to the management of debts
Assessment context
In the Credit and Debt Management unit you should be prepared to identify the various sources
of information when reaching a credit assessment decision and also to identify the usefulness of
this information in different circumstances.
Qualification context
You may have met different sources of information on other units of the AAT qualification;
however, the assessment of customer credit and credit control is primarily dealt with in the Credit
and Debt Management unit.
Business context
Credit management can be considered one of the most important factors in business survival.
Even the most profitable of businesses may run into trouble if cash is not available to pay their
debts as they fall due. An example can be when a business is unable to pay staff as money is
owing to the business from debtors. Ensuring receivables pay on time helps to maintain an
appropriate level of cash in the business. This is where having an effective credit management
policy and credit assessment process becomes crucial.
1
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Chapter overview
Liquidity
Ordering
cycle

Order placed

Credit offered

Goods despatched

Invoice sent

Working capital

Cash availability
Role of credit control
function
Credit control policy
Settlement discounts
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Collection
cycle
Managing the granting
of credit
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
Invoice received

Statement sent

Reminders

Cash received
Introduction
Credit management is about organisations having appropriate procedures to manage the
granting of credit to customers and having effective credit control systems to ensure that
customers settle their accounts as agreed.
Having good credit management will help ensure that there will be enough cash on hand to pay
obligations as they fall due. Having adequate cash, or assets that can be converted into cash, is
known as liquidity.
Liquidity is the ability of an organisation to pay its suppliers on time, meet its operational costs
such as wages and salaries and to pay longer-term outstanding amounts such as loan
repayments. Adequate liquidity is often a key factor in contributing to the success or failure of a
business.
Examples of liquid assets include: cash, short-term deposits, trade receivables and inventories.
These component parts are called the working capital of a business.
Assessment focus point
The importance of liquidity is one of the fundamental aims of the Credit and Debt
Management unit and any improvement in the credit management of an organisation will help
improve the liquidity of an organisation.
Illustration 1
A company has receivables outstanding of £20,000 that it hopes to receive from customers in 4
weeks. In the meantime, the company has an obligation to pay its own suppliers £16,000 in 2
weeks. The company has £10,000 in the bank and a further £10,000 available as an overdraft
facility.
Clearly, the company will not have enough cash to pay the full £16,000 to suppliers in 2 weeks.
One option open to the company would be to settle the £16,000 by £10,000 from the bank and
use £6,000 from the overdraft facility; however, the use of short-term finance such as an
overdraft can work out expensive. Alternative options would be to renegotiate a longer payment
with suppliers or encourage customers to pay more quickly.
Activity 1: Comparing financial position
The following table shows a summary of three businesses: A, B and C.
Required
Identify which business is in the weakest financial position.
Extract from accounting records
Business A
Business B
Business C

Cash: £2,000

Trade receivables payment expected this week: £2,500

Rent payable today: £1,500

Cash: £200

Trade receivables now overdue: £3,000

Wages payable at end of week: £1,000

Cash: £1,000

Trade receivables payment expected next week: £5,000

Electricity bill payable in two weeks: £1,200

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1 The role of credit control
1.1
Cash and credit transactions
We must be quite clear about the distinction between transactions which are for cash and those
which are on credit.
A cash transaction is one that takes place either with coins and notes, a cheque, a credit card or
a debit card. Cash transactions are basically those for which money will be available in the
business bank account almost immediately, once the amounts have been paid into the bank.
A credit transaction is one where the receipt or the payment is delayed for a period of time, as
agreed between the two parties to the transaction. Many business sales and purchases are made
on credit, whereby the goods are delivered or received now but payment is agreed to be received
or made in, say, 30 or 60 days.
1.2
Granting credit
The decision as to whether or not to grant credit to customers is an important commercial
decision. The granting of credit to customers means that they will be able to delay payment for
goods purchased – but this delay is an important marketing aspect of business that almost
always leads to a greater level of sales.
The benefit of offering credit to customers is, therefore, additional sales and accompanying
profits. However, there are also costs involved in offering credit:
(a)
Interest cost – if money is received later from customers, then the business is either losing
interest, as it does not have the money in its bank account, or is being charged more
interest on any overdraft balance
(b)
Irrecoverable debts cost – if sales are made for cash, then the money is received at the
time of the sale; with a credit sale there is always some risk that the goods will be
despatched but never paid for
Despite these costs of granting credit, most businesses trade on a credit basis with at least some
of their customers due to the benefits of additional sales and competitive advantage.
Assessment focus point
In the assessment, it is likely you will need to discuss whether to offer credit to a new customer
or extend credit to an existing customer. When approaching these types of questions, always
fully explain and justify your response, taking into account all the information given in the task
– for example, costs from lost interest in allowing credit and the risk of irrecoverable debts.
As we have seen, there are two main costs involved in trading with customers on credit: the
interest cost and the irrecoverable debts cost. The role of the credit control function is to
minimise these costs.
In a small organisation, the credit control function may consist of a single member of the
accounting operation, but in a larger institution, the credit control function may be an entire
department.
There are two main stages in the credit control function:


The ordering cycle
The collection cycle
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1.3
The ordering cycle
The ordering cycle can be illustrated:
Customer places
order
Customer credit
status established
Customer offered
credit
Goods despatched
Goods delivered
Invoice despatched
1.4
The collection cycle
The collection cycle starts where the ordering cycle finishes:
Customer receives
invoice
Statement sent
to customer
Reminder letters
sent to customer
Telephone calls
to customer
Cash received
1.5
Supply of goods and of services
A business may be supplying either goods or services to a customer. A manufacturing or
wholesale organisation will be selling goods to another business, whereas a service company
(such as an accountancy firm or a cleaning contractor) will be providing services. Whatever the
type of company, they are likely to be offering credit to their customers.
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Activity 2: The ordering cycle stages
Required
What are the main elements of the ordering cycle for goods to be sold on credit?
2 Credit control policy
A credit control policy is a policy that sets out the terms and conditions when supplying goods or
services on credit. Each business has its own credit control policies and procedures but all tend to
cover the following areas:






2.1
Assessment of credit standing of new customers
Assessment of credit standing of existing customers
Customers exceeding credit limits
Terms and conditions of credit granted
Payment methods allowed
Collection procedures
Terms and conditions of credit granted
The credit terms offered to a customer are part of the agreement between the business and the
customer and as such should normally be in writing. The terms of credit are the precise
agreements with the customer as to how and when payment for the goods should be made. The
most basic element of the terms of credit is the time period in which the customer should pay the
invoice for the goods. There are a variety of ways of expressing these terms:
2.2

Net 10/14/30 days – payment is due 10 or 14 or 30 days after the invoice date

Net monthly – payment is due within a month of the invoice date

Weekly credit – all goods must be paid for by a specified date in the following week

Half-monthly credit – all goods delivered in one-half of the month must be paid for by a
specified date in the following half-month

Monthly credit – all goods delivered in one month must be paid for by a specified date in
the following month
Settlement and cash discounts
In some cases, customers may be offered a settlement discount or cash discount for payment
within a certain period which is shorter than the stated credit period.
The terms of such a settlement discount may be expressed as follows:
Net 30 days, 2% discount for payment within 14 days.
This means that the basic payment terms are that the invoice should be paid within 30 days of its
date but that if payment is made within 14 days of the invoice date, a 2% discount can be
deducted. It is up to the customer to decide whether or not to take advantage of the settlement
discount offered.
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Activity 3: Settlement and cash discounts
Offering settlement discounts can have advantages and disadvantages for the business offering
the discount.
Required
Identify possible advantages and disadvantages of such a policy below.
Offering settlement discounts to customers
Advantages
Disadvantages
Activity 4: Identification of terms and conditions
Required
If an invoice includes the term 'net monthly', what does this mean?

Invoice must be paid in the month of issue of invoice
Invoice must be paid the month after the invoice date
Invoice must be paid within a month of the invoice date
Invoice must be paid net of any discount within a month of the invoice date
Assessment focus point
In the assessment, you may be asked to identify key areas of a credit control policy and give
reasons or justify why the policy has specific procedures included in the policy.
Illustration 2
It is important to have procedures for accepting credit applications from new customers, as there
will be no record of trading history to base a credit application decision upon. Why would it be
necessary, though, to have procedures for existing customers?
Procedures for assessing the credit standing for existing customers are needed as existing
customers may be looking to increase their credit limit or negotiate new terms of business
regarding discounts and credit periods.
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Activity 5: Policies and procedures
Required
Explain why a credit control policy should contain procedures for customers who have
exceeded their credit limits.
3 Assessment of credit status
The decision to grant credit to a customer is an extremely important commercial judgement. The
granting of credit to a customer normally leads to continued and possibly increasing sales to that
customer. However, there are also risks involved:
(a)
The customer may extend the period of credit by not paying within the stated credit
period and, therefore, deprive the seller of cash which may be vital for the purposes of cash
flow.
(b)
The customer may never pay at all if, for example, they went into liquidation with no
money available to pay creditors.
Therefore, a very important role of the credit controller is to be able to assess the credit status of
customers to determine whether or not they should be granted a period of credit, how long that
credit period should be and what their credit limit should be. This role applies not only to new
customers of the business but also to established customers who may wish to increase their credit
limit or renegotiate their credit terms.
3.1
What is the credit controller looking for?

Will the customer pay within stated credit terms?

Will the customer's business remain solvent?

Will any risk of late or non-payment be acceptable when compared to the additional sales
expected?
Activity 6: Risks of granting credit
Required
What are the risks of granting credit to a customer?
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3.2
Assessment process
The process of assessing a customer's credit status, and possible actions, can be illustrated:
Existing customer
increasing
credit limit
REQUEST FOR
CREDIT
New customer
requesting
credit
Internal
sources of
information
ASSESSMENT
PROCESS
External
sources of
information
DECISION?
Grant
credit
Refuse
credit
Formal
credit terms
Trade on a cash
only basis
Reassess in future
3.3
Communication of assessment decision
Once a decision has been taken to grant credit to a customer, then the details of the credit limit
and terms and conditions of trading and payment will be communicated to the customer in
writing. If the credit application has been refused, then the reasons for the refusal will be
communicated to the customer, also in writing.
4 Sources of information
When assessing the credit status of either an established or a new customer, there are a variety
of sources of information that the credit controller can draw upon. Some are external to the
business and others are internal.
Remember that the credit controller is concerned about the customer's ability and tendency to
pay within the stated credit terms and also that the customer will remain solvent. No single source
of information can guarantee either of these but there are a variety of sources which can be
considered; all of the information can be pooled for a final decision on credit status to be made.
The sources of information available for assessing a customer's credit status include the
following:
External sources








Bank reference
Trade reference
Credit reference agencies
Credit circles (sharing of credit information between businesses)
Companies House (for published financial statements)
Management accounts from the customer
Media publications
The internet
Internal sources

Staff knowledge communicated by conversations, emails and meetings

Customer visits

Calculation of performance indicators (financial analysis) of either external published
financial statements or internal management accounts provided by the customer
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
Credit scoring of performance indicators

Previous trading history
Activity 7: Sources of information
Sources of credit status information can come from a variety of sources.
Required
Indicate whether each of the following sources of information for assessing the credit status of
customer is internal or external.
Source
Reference obtained from a credit reference agency
Calculation of performance ratios from the customer's financial
statements
Conversations with a company's own sales team for feedback
on a customer's trading reputation
Entering a customer's name into an internet search engine
Visiting a customer's premises when viewing or demonstrating
some samples
Reviews in a trade publication
Analysis of an aged receivables report
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Internal or external?
Chapter summary
 Adequate liquidity is often a key factor in contributing to the success or failure of a business. The
liquidity of a business is the availability of cash or assets which can easily be converted into cash.
 The benefit of offering credit to customers is the likely increase in sales. However, there are also
costs of lost interest and potential irrecoverable debts. The role of the credit control function is to
minimise these costs.
 The credit control function is involved in the ordering cycle in establishing customer credit status
and offering credit terms and also throughout the collection cycle.
 Every business will have its own credit control policies, terms and conditions regarding how and
when payment is to be made by credit customers.
 When evaluating a customer's credit status the concerns are to ensure that the customer will pay
within the stated credit terms and that the business will remain solvent.
 When either a potential new customer requests credit or an existing customer requests an
increase in credit limit, the credit controller will make use of internal and external information
about the customer, in order to determine whether or not the request should be granted.
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Keywords

Cash transaction: One that takes place either with coins and notes, a cheque, a credit
card or a debit card

Collection cycle: The process from the sending out of the sales invoice to the receipt of
cash from a customer

Credit control function: The person or department responsible for minimising the interest
and irrecoverable debt cost involved in trading with customers on credit

Credit control policy: A policy that sets out terms and conditions when supplying goods or
services on credit

Credit control system: A system to ensure that customers settle their accounts as agreed
and that adequate liquidity is maintained for the organisation

Credit transaction: One where the receipt or the payment is delayed for a period of time,
as agreed between the two parties to the transaction

Liquidity: The ability of the business to pay its suppliers on time and to meet other
operational costs

Ordering cycle: The process from when a customer places an order to the sending out of
the sales invoice

Settlement and cash discounts: A discount offered for payment within a shorter period
than the stated credit terms

Terms of credit: The precise agreements as to how and when a customer is due to pay for
goods purchased
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Test your learning
1
2
Which of the following are the main costs of making sales on credit?
(i)
(ii)
(iii)
(iv)
Loss of customers
Loss of interest
Loss of goodwill
Irrecoverable debts
A
B
C
D
(i) and (ii)
(ii) and (iii)
(i) and (iv)
(ii) and (iv)
Which of the following is not a main element of the collection cycle which will be part of
the role of the credit control function within an organisation?
A
B
C
D
3
Customer receives reminder letter
Customer receives statement
Customer receives invoice
Customer places order
A company sets a credit policy of normal payment within 14 days but a 3% settlement
discount for payment within 7 days.
How would this policy be expressed on an invoice?
4
A potential new customer approaches your business with a request for credit facilities.
Which of the following are processes that would be followed by the credit controller?
5
(i)
(ii)
(iii)
(iv)
(v)
Analysis of external information
Analysis of aged receivables listing
Analysis of payment history
Analysis of internally produced ratios
Communication of decision to customers
A
B
C
D
(i), (ii), (iii), (v)
(ii), (iii), (iv)
(i), (iv), (v)
All of them
Are credit circles an internal or external source of credit information?
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Granting credit to
customers
Syllabus learning outcomes/objectives
2.1
Sources of credit status and assessment methods used in granting credit
Learners need to understand:


2.2
The range of internal and external sources of information:
–
External sources: credit agencies, trade and bank references, published
financial statements, management accounts, publications and credit circles
–
Internal sources: records, conversations, emails, staff visits, calculation of
performance indicators, credit scoring of performance indicators
The usefulness and appropriateness of different types of information
Credit status of existing and potential customers using relevant ratios and
performance indicators
Learners need to understand:

The signs of overtrading

The implications of overtrading
Learners need to be able to:

Analyse performance indicators of existing credit customers and/or potential
credit customers

Calculate liquidity indicators: current ratio, quick ratio (acid test), trade
receivables collection period (days), trade payables period (days) and inventory
holding period (days)

Calculate profitability indicators: gross profit margin, operating profit margin,
and return on capital employed (ROCE)

Calculate debt indicators: gearing and interest cover

Calculate the working capital cycle (days)
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2.3
Reasons for granting, refusing, amending or extending credit
Learners need to understand:
3.1

Organisational policies and procedures specific to changes to credit terms

How to assess and communicate changes to credit terms

Threats to objectivity that may exist when deciding whether to grant, refuse,
amend or extend credit
Methods for the management of debts
Learners need to understand:

The characteristics of an effective credit control system

Organisational policies and procedures specific to the management of debts
Assessment context
The calculation of financial ratios and the communication of assessment decisions are an
extremely important part of the Credit and Debt Management unit and is very likely to appear on
the assessment. Students must be able to calculate and interpret financial ratios and
performance indicators correctly and present results to the required decimal places. Appropriate
credit decisions can then be communicated to potential customers, based on the calculations
made.
Qualification context
The calculation of financial ratios and other performance indicators can also appear in the
Level 4 unit Drafting and Interpreting Financial Statements.
Business context
Businesses that trade on credit rely on the credit control function to arrive at the correct credit
assessment decision. An inappropriate credit decision can result in irrecoverable debts if
customers fail to pay or loss of valuable sales from customers who have been incorrectly refused
credit.
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Chapter overview
Sources of information

Internal

External
Granting credit to customers
Bank
references
Trade
references
Credit
reference
agencies
Financial ratios
Scoring
Credit assessment
Communication of credit
assessment decision

Acceptance

Refusal
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Introduction
In this chapter we consider how to evaluate the credit status of existing and new customers. This
process will be undertaken by using a variety of information collected from both internal and
external sources. You will need to be able to extract relevant information and to prepare
calculations based upon the information provided. Once the customer's information has been
assessed, then the credit terms can be agreed. Alternatively, it may be necessary to refuse credit
at this stage and this must be communicated to the customer.
The credit controller is concerned about the customer's ability and tendency to pay within the
stated credit terms and also that the customer will remain solvent. No single source of information
can guarantee either of these, but there are a variety of sources which can be considered; all of
the information can be pooled for a final decision on credit status to be made.
1 External sources of information
If the credit controller wishes to assess the solvency of the customer and the likelihood of them
paying within the stated credit period, then two of the most obvious potential sources of
information are the customer's bank and other suppliers that the customer uses.
When a new customer approaches the business with an order and a request for credit, it is
normal practice for the credit controller to ask for a bank reference and, normally, two trade
references. The business will make a request to the new customer for details of their bank and for
details of two other suppliers with whom they regularly trade. This may be done in a letter or,
more usually, by sending the customer a standard credit application form.
1.1
Bank references
Care needs to be taken when interpreting bank reference replies. The banks have two
considerations when replying to a request for a reference regarding a customer:

Confidentiality of the customer's affairs

Accusations of negligence from the recipient of the reference if the reference proves to be
wrong
As a consequence, bank references tend to all be worded in a similar manner with a well-known
'real' meaning. Examples of the most commonly used phrases as a reply to a request for a credit
reference, and their 'real' meaning, are as follows:
Bank's reply
The customer's credit for £x is:
Real meaning
Undoubted
The best type of reference – the customer
should be of low risk for the figures stated
Considered good for your purposes
Probably OK and a reasonable risk but not as
good as 'undoubted'
Should prove good for your figures
Not quite as certain as the other two and
therefore warrants further investigation
Well-constituted business with capital seeming
to be fully employed: we do not consider that
the directors/owners would undertake a
commitment they could not fulfil
Not very hopeful – this probably means the
business has cash flow problems and credit
should not be extended to them
Unable to speak for your figures
The worst – the bank seems to believe that the
business is already overstretched – definitely
no credit to be granted
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1.2
Trade references
Once the business has received details of trade referees from the potential customer, it is
standard practice to send out a letter asking for information from them. Typical information
requested can include: length of time traded with, credit terms, payment record and any
problems with the account.
1.3
Problems with trade references
(a)
Some firms deliberately pay two or three suppliers promptly in order to use them as trade
referees, while delaying payment to their other suppliers.
(b)
The trade referee may be connected or influenced in some way by the potential customer.
For example, it may be a business owned by one of the directors of the customer.
(c)
The trade referee given may not be particularly strict themselves regarding credit control,
therefore their replies might not be typical – the genuine nature of the trade referee should
be checked.
(d)
Even if the reference is genuine and favourable, it may be that trade with this supplier is on
a much smaller basis or on different credit terms to that being sought by the customer.
Activity 1: Bank reference reply
What would be the typical response of a credit controller to a bank reference which reads
'unable to speak for your figures'?
A
B
C
D
Grant credit
Further investigation of external information
Do not grant credit
Further investigation of internal information
Activity 2: Interpreting references
You are the credit controller for a company. You have issued a standard request for bank and
trade references in connection with a potential new customer and received the replies set out
below.
The potential customer, Conrad Ltd, wishes to trade on credit with your company and has asked
for a credit limit of £8,000 with terms of payment within 45 days of the invoice date.
Bank reference: Conrad Ltd
Supplied by Bourne Bank
'The customer's credit for £8,000 is considered good for your purposes.'
Trade reference: Conrad Ltd
Supplied by XYZ Ltd
How long has the customer been trading with you?
6 mths
Your credit terms with customer per month
£ 5,000
Period of credit granted
..............45 days...............
Payment record
Prompt /occasionally late/slow
Have you ever suspended credit to the customer?
Yes/ No
If yes – when and for how long?....................................................................
Any other relevant information .....................................................................
.....................................................................................................................
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Required
What, if any, conclusions could you draw from the above references?
1.4
Credit reference agencies
Credit reference agencies are commercial organisations which specialise in providing a variety of
information regarding the credit status of companies and individuals. These agencies have large
databases of information and can provide historic information such as financial reports, directors'
details, payment history, any insolvency proceedings or bankruptcy orders for individuals, and
bankers' opinions. They will sometimes also provide a credit rating.
Examples of credit reference agencies in the UK are Equifax, Dun & Bradstreet and Experian.
It must be borne in mind that they are a summary of only some of the information about the
customer and that they may be based upon out-of-date historical data.
1.5
Credit circle
Credit circles are groups of companies which are usually competitors; this means that they tend
to have customers or potential customers in common. Often such groups of companies will meet
formally every few months to discuss relevant matters and also communicate informally on a
more regular basis.
1.6
Financial statements
If the potential customer is a company, then it must file certain financial information regarding its
annual accounts and directors with Companies House. This information can be accessed by
anyone but is unlikely to be particularly up to date, as companies need not file their annual
accounts until some considerable time after their year end.
1.7
Management accounts
Most businesses keep monthly management accounts. Most are in the form of a statement of
profit or loss and statement of financial position. Some may keep a cash flow report. The purpose
of these accounts is to enable the owners and managers of the business to monitor the business'
performance against budget and to take corrective action if necessary. Therefore, these
accounts are more up-to-date than published financial statements, but it must be remembered
that their form is designed to meet the needs of the business concerned and they are not subject
to external audit or other checks.
1.8
Publications and the internet
More up-to-date information can also often be found about a customer from various media
sources. Newspapers such as the Financial Times run articles on many companies, as do various
trade journals. The internet is a powerful tool for information and, by running a search on a
company name, you may be able to find a number of useful articles and updates.
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2 Internal sources of information
Internal sources of information about an existing or potential customer can include information
from employees within the organisation and information that is analysed by employees. In most
cases, the employees of a business will have little information about potential customers but
should have a good level of knowledge of existing customers.
Internal sources of information can include:
2.1
Business records and reports
For example, payment records and past orders. An aged receivables analysis is an important
internal report and we will look at this specific report in some depth in a later chapter.
2.2
Staff meetings and conversations
Staff meetings can be held on a regular basis to discuss payment patterns and transactions of
customers, or on an ad hoc basis to discuss particular customers.
2.3
Emails
Internal email records concerning customers is a potential source of information. Emails between
the business and the customer are also an internal source of information because they come from
the business' own email system.
2.4
Staff knowledge
The sales staff deal with customers on a regular basis. They are likely to have opinions as to how
well a customer is doing and how efficient it is. The sales ledger staff will be able to provide
information about the payment history of the customer and if it has been staying within credit
limits.
2.5
Customer visits
Some internal staff, particularly the sales team, are likely to pay fairly regular visits to the
customer's premises and they should be able to provide feedback as to how prosperous and
efficient the customer appears to be.
3 Financial ratio analysis
The purpose of analysing financial statements and management accounts for credit control
assessment is to find indicators of the customer's performance and position in four main areas:




Profitability indicators
Liquidity indicators
Debt indicators
Cash flow indicators
In general terms, this analysis is only useful if it is carried out over a period of time (at least the
last three years) to determine any trends in business performance.
3.1
Profitability ratios
When credit has been granted, one major concern will be the profitability of the customer. If the
customer is not profitable in the long term, then it will eventually go out of business and this may
mean a loss in the form of an irrecoverable debt, if it has been granted credit.
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The main profitability ratios that will give indicators of the customer's long-term profitability are:




Gross profit margin
Operating profit margin
Return on capital employed
Net asset turnover
Formula to learn
Gross profit margin
Gross profit
 100%
Revenue
This gives an indication of how profitable the trading activities of the business are. This would be
expected to remain fairly constant or increase over time.
Formula to learn
Operating profit margin
O perating profit
 100%
R evenue
Operating profit (or profit from operations) is profit after all expenses have been deducted; it
therefore indicates the overall profitability of the business.
Activity 3: Gross profit margin and operating profit margin
A company has a revenue of £137,500. Gross profit amounts to £27,500 and, after operating
expenses are deducted, operating profit amounts to £13,750.
Required
Calculate the gross profit margin percentage and operating profit margin.
%
Gross profit margin
Operating profit margin
Formula to learn
Return on capital employed (ROCE)
Operating profit
 100%
Capital employed
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This is the overall profit indicator showing the profit as a percentage of the capital employed of
the business. This should increase or remain constant over time.
Capital employed is calculated as: Total equity + non-current liabilities
Formula to learn
Net asset turnover
Revenue
C apital em ployed
This ratio, measured as the number of times that revenue represents capital employed, shows the
efficiency of the use of the capital employed in the business.
Activity 4: Return on capital employed
A company has a gross profit of £152,000 and operating profits of £76,000. Share capital is
£200,000, reserves total £188,000 and there is a long-term loan of £100,000.
Required
Calculate the company's return on capital employed (to one decimal place).
%
Return on capital employed
3.2
Liquidity ratios
The purpose of calculating liquidity ratios is to provide indicators of the short-term and mediumterm stability and solvency of the business. Can the business pay its debts when they fall due?
Liquidity indicators can be considered in total by the calculation of two overall liquidity ratios:


Current ratio
Quick ratio or acid test ratio
Liquidity and working capital management can also be examined by looking at the individual
elements of the working capital of the business and calculating the:



Inventory holding period
Trade receivables collection period
Trade payables payment period
Formula to learn
Current ratio
Current assets
Current liabilities
This is a measure of whether current assets are sufficient to pay off current liabilities. It is
sometimes stated that the ideal ratio is 2:1 but this will depend upon the type of business.
In computer-based tasks, you should enter the ratio as a number, entered to the specified
number of decimal places if applicable. A ratio of 2:1 would be entered as 2 (since 2/1 = 2). If the
ratio was 1:2, then it would be entered as 0.5 (since 1/2 = 0.5).
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Activity 5: Current ratio
A company's current assets are £3,930 and current liabilities amount to £2,620.
Required
(a)
Calculate the current ratio.
The company has now spent £1,530 out of the bank account and current liabilities have the
remained the same.
Required
(b)
Calculate a revised current ratio.
(c)
What impact would your results in (a) and (b) be on your credit assessment for the
company?
Formula to learn
Quick ratio/acid test ratio
Current assets – inventories
Current liabilities
Inventory is removed from the current assets in this measure of liquidity, as it tends to take longer
to turn into cash than other current assets. It is sometimes stated that the ideal ratio is 1:1 but
again, this is dependent upon the type of business.
Formula to learn
Inventory holding period (days)
Inventories
 365 days
Cost of sales
The inventory holding period (sometimes called inventory turnover) measures how many days, on
average, inventory is held before it is sold. This will depend upon the type of inventory but should
ideally not increase significantly over time.
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Formula to learn
Trade receivables collection period (days)
Trade receivables
 365 days
Revenue
This measures how many days, on average, it takes for receivables to pay and is sometimes also
referred to as receivables' turnover. It shows the average period of credit taken by customers. This
will depend upon the type of business and the credit terms that are offered. Ideally, it should be
around the average credit period offered to credit customers and similar to the time taken to pay
suppliers.
In an assessment, if you are given a figure for 'credit sales' you should use that instead of
revenue. Alternatively, you may be able to calculate credit sales as 'revenue less cash sales' if a
figure for cash sales is provided.
Formula to learn
Trade payables payment period (days)
Trade payables
 365 days
C ost of sales
The trade payables payment period (sometimes called payables' turnover) measures how many
days, on average, the business takes to pay its trade payables. This is of direct relevance as it will
give an indication of how long a period of credit the business normally takes from its suppliers.
In an assessment, if you are given a figure for 'credit purchases' you should use that instead of
cost of sales. Alternatively, you may be able to calculate credit purchases as 'cost of sales less
cash purchases' if a figure for cash purchases is provided.
3.3
Working capital cycle
The working capital cycle (or operating cycle) measures the period of time from when cash is
paid out for raw materials until the time cash is received in from customers for goods sold.
The stages in the cycle are as follows:
(1)
A firm buys raw materials, probably on credit.
(2)
It holds the raw materials for some time in stores before they are issued to the production
department and turned into finished goods.
(3)
The finished goods may be kept in a warehouse for some time before they are eventually
sold to customers.
(4)
By this time, the firm will probably have paid for the raw materials purchased.
(5)
If customers buy the goods on credit, it will be some time before the cash from the sales is
eventually received.
The working capital cycle or operating cycle of a business in days is calculated as:
Days
Inventory holding period
X
Trade receivables collection period
X
X
Less trade payables payment period
(X)
Working capital cycle
X
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Activity 6: Working capital cycle
A company has revenue of £980,000 and cost of sales of £686,000. Inventories at the year end
are £77,000, trade receivables are £130,000 and trade payables are £89,000.
Required
(a)
Complete the table below by calculating the indicators below to the nearest day.
Days
Inventory holding period
Trade receivables collection period
Trade payables payment period
(b)
3.4
Using your results in (a) above, how long is the working capital cycle?
Debt indicators
When assessing a customer's credit status, the credit controller will also be concerned with the
longer-term stability of the business. One area of anxiety here is the amount of debt in the
business's capital structure and its ability to service this debt by paying the periodic interest
charges.
The main measures are:


Gearing ratio
Interest cover
When looking at the total debt of the business, the company may also analyse debt into that
payable in the short term and that payable in the long term. The short-term debt ratio can help
assess what proportion of total debt is payable sooner rather than later.
Formula to learn
Gearing ratio
Total debt
 100%
Total debt + Total equity
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Total debt includes borrowings and loans found in non-current liabilities only.
Debt may be referred to in the assessment as 'borrowing' or 'loans' when it is included in the
statement of financial position.
The gearing ratio is often stated as ideal at 50% or less, although this will again vary between
different industries and different businesses. The higher the figure, the more risky the company
may appear to be.
Assessment focus point
In the assessment look out for information explaining whether debt is long- or short-term. Only
debt which is a non-current liability should be included in the total debt used by the business.
Also look out for companies that may be using finance or operating leases to purchase or use
non-current assets. Accounting for leases can be a complex area; however, a company that is
entering into excessive lease arrangements may be considered to have a higher risk attached
due to these obligations.
Formula to learn
Interest cover
Operating profit
Finance costs
The interest cover is calculated as the number of times that the interest (or finance costs) could
have been paid; it represents the margin of safety between the profits earned and the interest
that must be paid to service the debt capital. Interest cover can also be a good indicator of the
profitability of a business.
3.5
Cash flow indicators
In most of the calculations so far, profit has been used to calculate various ratios. However, there
are many users of accounts who believe that this figure is subject to management and
accounting policies, so a further figure of EBITDA is often used in calculations.
This is earnings before interest, tax, depreciation and amortisation and means taking the
earnings before profit and tax figures, and then adding back any interest, depreciation and
amortisation charges.
It is argued that using this figure removes the subjective figures of depreciation and amortisation
from the profit figure and gives a closer approximation to the underlying cash flows. This figure
can then be used to calculate a number of further ratios which can be useful in assessing the
cash flow situation of a business.
Formula to learn
EBITDA interest cover
E B IT D A
In te re st p a y a b le
This is the same calculation as for interest cover but using EBITDA instead of profit before interest
and finance costs instead of interest, although interest and finance costs are essentially the
same.
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Formula to learn
EBITDA to total debt
EBITDA
 100%
Total debt
This is a measure of the profits/cash flows available in comparison with the total debt of the
company. It can give an indication of the ease with which the company can service its debt
commitments from operations.
Activity 7: Cash flow indicators
A company has share capital of £200,000, reserves totalling £188,000 and a loan of £100,000.
The operating profit for the year is £45,000, after deducting depreciation of £12,000 and interest
of £6,000.
Required
Calculate the company's gearing ratio, interest cover and EBITDA-based interest cover (to one
decimal place).
Workings
Gearing ratio (%)
Interest cover
EBITDA-based interest cover
Assessment focus point
When calculating percentages always remember to multiply by 100. For example, if
calculating 50 out of 200, the calculation is 50/200  100 = 25% and not 0.25.
Also be careful to follow rounding requirements. For example, if in the assessment you are
asked to round to two decimal places, then 26.174% would become 26.17% and 26.176% would
become 26.18%. By convention when a figure ends in a '5' this is rounded up. For example,
26.175% would also become 26.18% when presented to two decimal places.
4 Preparing a credit assessment report and
recommendation
There are a number of internal and external sources of information available to the credit
controller in their attempt to assess the current credit status of an existing or potential customer.
It is likely that the credit controller will review most, if not all, of these sources of information and
then use the information gathered to make a decision about the customer's credit status.
This may be a clear-cut judgement where the bank reference is favourable, the trade references
are sound and the analysis of the financial statements indicates a profitable and liquid business.
Such a business would appear to be low risk and should be granted credit.
At the other end of the scale, the bank and trade references may be unsatisfactory and an
assessment of the financial statements may indicate problems with profitability and liquidity. This
is a high-risk business and trade should probably only be carried out on a cash basis. In many
scenarios, the situation may not be clear cut and the credit controller must assess conflicting
information to determine the best course of action.
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Assessment focus point
In the assessment you may need to reach a credit assessment decision and justify how you
reached your decision. In written answers, it can be useful to state the financial ratios
calculated, explain whether results are improving or deteriorating and provide possible
reasons why ratios are changing and highlight any potential problems regarding profitability,
liquidity or gearing.
If a task asks for a recommendation on whether to grant or refuse credit, then ensure that you
provide one!
When answering, make your point, state your evidence, explain what this means or what the
consequences are and then make a recommendation if one is requested.
Activity 8: Making a credit assessment decision
Your name is Tom Hunt, the credit controller at SC Fuel and Glass, and you are considering the
request for £15,000 a month of credit facilities for Haven Engineering Ltd. The following
references and financial statements have now been received:
Bank reference
Haven Engineering Ltd – should prove good for your figures.
Trade reference 1
Payment occasionally late and have suspended credit in the past.
Trade reference 2
Payment occasionally late and credit never suspended.
Summarised financial statements for the three years ending 31 December 20X6, 20X7 and 20X8.
Summarised statements of profit or loss
Year ending 31 December
20X6
£000
20X7
£000
20X8
£000
3,150
3,220
3,330
Cost of sales
(2,048)
(2,061)
((2,115)
Gross profit
1,102
1,159
1,215
Operating expenses
(645)
(676)
(732)
Operating profit
457
483
483
Finance costs
(95)
(100)
(120)
Profit before taxation
362
383
363
Revenue
Taxation
(91)
(96)
Profit for the year, after taxation
271
287
(91)
272
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Summarised statements of financial position
As at 31 December
20X6
£000
20X7
£000
20X8
£000
3,339
3,727
4,112
Inventory
292
328
353
Receivables
639
670
684
2
2
2
933
1,000
1,039
4,272
4,727
5,151
Ordinary share capital
1,000
1,000
1,000
Retained earnings
1,020
1,307
1,579
Total equity
2,020
2,307
2,579
1,600
1,800
2,000
Trade payables
494
474
463
Other liabilities
158
146
109
652
620
572
Total liabilities
2,252
2,420
2,572
Total equity and liabilities
4,272
4,727
5,151
Assets
Non-current assets
Current assets
Cash at bank
Total assets
Equity and liabilities
Equity
Non-current liabilities
Borrowing
Current liabilities
The borrowings are long-term loans. Finance costs consists of interest payable.
Required
In your role as credit controller, assess the information available regarding Haven Engineering
Ltd.
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4.1
Overtrading
When assessing the financial health of a business, including prospective customers, one thing to
be mindful of is the possibility that the business could be overtrading.
Overtrading occurs when a business takes on a high volume of work and attempts to complete it,
but discovers it does not have the required level of resources to do so. It may be that the business
needs more employees, working capital (including cash) or assets than are available to it.
Overtrading is common when a business is just starting out and when a company is growing very
rapidly (too rapidly and taking on too much new business). The business finds itself having to pay
a lot of cash (eg to buy inventory, pay wages and pay the rent) before collecting cash from
customers, since the customers have been allowed a period of credit (and in any case, customers
are not guaranteed to pay on time). As a result, the business can run short of cash and may not
be able to continue to pay its liabilities as they fall due.
There are a number of signs of overtrading, including:

Rapidly increasing sales revenue as a result of offering increased periods of credit to
customers, or offering credit to less creditworthy customers
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
Increasing receivables and inventory levels, indicating more funds tied up and not readily
converted to cash

An overdraft for the first time, or an increase in an existing overdraft or other short-term
debt that has been required to meet cash shortages

Payables have increased, as the business has been forced to take longer to pay suppliers

Reduced margins may be apparent if prices are discounted to grow revenue
It is important to note that the above signs may not necessarily mean there is an overtrading
problem with a business, especially if there is only one of the signs present. As always, it is
important that a number of indicators are considered together. However, if a number of the signs
are present for a particular business, the possibility of overtrading should be taken into account
when deciding whether to offer credit.
Illustration 1
The financial statements of ABC Ltd have been analysed and the following information is
available:
20X8
20X7
45%
36%
Inventory holding period
63 days
55 days
Trade receivables collection period
57 days
45 days
65%
47%
Gross profit margin
Gearing ratio
Conclusion:
The gross profit margin has increased from 36% to 45%, showing an apparently healthy increase.
However, the inventory holding period and the receivables collection period have both increased.
This means that money is tied up in inventory for longer before being turned into cash and that it
is taking longer to collect money from customers.
It could be that customers are being offered more generous credit terms to encourage them to
buy more, but it could also mean that ABC Ltd is selling to new customers who are taking longer
to pay. Finally, the gearing ratio shows a large increase over the previous period. It could be that
ABC Ltd is borrowing more, in order to invest in new assets to expand the business. Alternatively,
the company may be borrowing more to cover reduced cash flow from holding inventories longer
and customers taking longer to pay. The signs are that ABC Ltd could be overtrading but further
investigation is needed.
5 Credit scoring
Credit scoring is a method of assessing the creditworthiness of an individual or organisation
using statistical analysis and is used by organisations such as banks, utility companies, insurance
companies and landlords to assess the ability of an individual or organisation to repay any loans
or pay for services or goods.
Information is entered into a scoring system, and a credit score is then calculated by weighting
the information. Using the credit score, lenders can predict with some accuracy how likely the
borrower is to repay a debt and make payments on time.
Leading credit reference agencies use data from multiple sources to create a comprehensive,
weighted score. Typically they will consider:

Financials – profitability, liquidity/solvency, gearing, any late filing of accounts or other
statutory documents

Business details – age, size, industry, number of employees
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Publicly available data – County Court Judgements, mortgages and charges

Payment record – payment trends, volatility, % of debts paid promptly or beyond terms

Owners – number, experience, track record

Economic index – risk and expectations relating to the specific industry under different
economic conditions
A business that can demonstrate timely payment of its obligations, assets which easily outweigh
its liabilities, a large amount of available credit and one that is not too highly geared will be
deemed low risk.
Late payments and high gearing will damage the score and any insolvency/bankruptcy,
judgements and foreclosure will almost certainly guarantee a failing grade.
The following credit rating (scoring) system table can be used to assess the risk of default by
calculating key indicators (ratios), comparing them to the table and calculating an aggregate
score.
Credit rating (scoring) system
Score
Operating profit margin
Losses
–5
Less than 5%
0
5% and above but less than 10%
5
10% and above but less than 20%
10
More than 20%
20
Interest cover
No cover
–30
Less than 1
–20
More than 1 but less than 2
–10
More than 2 but less than 4
0
More than 4
10
Current ratio
Less than 1
–20
Between 1 and 1.25
–10
Between 1.26 and 1.5
0
Above 1.5
10
Gearing
Less than 25%
20
25% and above but less than 50%
10
More than 50% but less than 65%
0
More than 65% but less than 75%
–20
More than 75% but less than 80%
–40
More than 80%
–100
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Credit rating (scoring) system
Score
Risk
Aggregate score
Very low risk
Between 60 and 21
Low risk
Between 20 and 1
Medium risk
Between 0 and –24
High risk
Between –25 and –50
Very high risk
Less than –50
Activity 9: Scoring of financial ratios
Your business uses a scoring system to rate potential new customers and ahead of an assessment
decision of a potential customer you have obtained a number of key financial ratios for two
years' results.
Only customers who are considered to be medium risk or lower are offered a credit facility.
Required
Using the credit rating system shown on the previous page, score the following financial ratios
and tick whether the application would be rejected or accepted for both years.
20X6
20X5
ABC Ltd
Ratio
Rating
Ratio
Operating profit margin
7%
11%
Interest cover
1.4
0.8
Current ratio
1.7
1.4
70%
55%
Gearing
Rating
Total credit rating


Reject credit application
Accept credit application
6 Communication of a credit assessment decision
Once a decision has been taken to grant credit to a customer, then the precise details of the
credit limit and all terms and conditions of trading and payment must be communicated to the
new customer in writing. Before this is done, the credit limit must be set for the customer. When
determining this, communication with the sales department will be useful to establish the
expected level of orders from this customer. For example, if the sales department expects the
customer to order £4,000 of goods per week and the credit terms are 30 days, then a credit limit
of, say, £10,000 would seriously limit the sales to this customer.
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6.1
Opening a new customer account
Once a decision has been made to grant credit to a customer, then a file and an account in the
trade receivables ledger must be set up. For this to take place, the following information will be
required:






6.2
The business name of the customer
The contact name and title within the customer's business
Business address and telephone number
The credit limit agreed upon
The payment terms agreed
Any other terms, such as settlement discounts offered
Refusal of credit
In some cases, the credit controller may decide that it is not possible to trade with a new potential
customer on credit terms.
Refusing to grant credit to a new customer is a big decision for the credit controller, as the
company will not wish to lose this potential customer's business – but the credit controller will
have taken a view that the risk of non-payment is too high for credit terms to be granted.
Refusal of credit does not necessarily mean that the potential customer's business is bad or is
likely not to survive; it simply means that, on the evidence available to the credit controller, the
chance of non-payment is too high for the company to take the risk.
There are a variety of reasons why a decision might be made not to grant credit to a new
customer and could include the following:








A non-committal or poor bank reference
Poor trade references
Concerns about the validity of any trade references submitted
Adverse press comment about the potential customer
Poor credit agency report
Information from a member of the business's credit circle
Indications of business weakness from analysis of the financial statements
Lack of historical financial statements available, due to being a recently started company
The credit controller will consider all of the evidence available about a potential customer and the
reason for the refusal of credit may be due to a single factor noted above or a combination of
factors.
6.3
Communication of changes or refusal of credit
If a credit facility is to be changed or not granted to a potential customer, then this must be
communicated in a tactful and diplomatic manner. The reasons for the change or refusal of credit
must be politely explained and any future actions required from the potential customer should
also be made quite clear. The credit controller, while not wishing to grant credit to the customer
at the current time, will also not necessarily want to lose their potential business.
In almost all cases, where credit is to be refused to a potential customer, the company should
make it quite clear that they would be happy to trade with the customer on cash terms.
In some situations, although the granting of credit to the new customer has currently been
refused, it may be that the credit controller wishes to encourage the customer to apply for credit
terms in the future. For example, with a newly formed company, there may be little external
information available on which the credit controller can rely at the present time – but if financial
statements and references can be provided in the future, then the decision as to whether or not to
trade on credit terms can be re-assessed.
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6.4
Communication method
In most cases, it is usually expedient to communicate the reasons for the refusal of credit initially
in a letter. In the letter, the credit controller may suggest that a telephone call may be
appropriate in order to discuss the matter and any future actions that may be necessary.
Illustration 2
Glowform Ltd has requested to trade with the SC Fuel and Glass on credit and would like a
£5,000 credit limit and 60 days' credit. Tom, the credit controller, requested two trade references,
a bank reference and financial statements for the last three years. Glowform Ltd has provided a
bank reference which states that the 'the company appears to be well-constituted but we cannot
necessarily speak for your figures due to the length of time that the company has been in
operation'. The company has also provided one trade reference which is satisfactory from a
company which allows Glowform Ltd £3,000 of credit on 30-day terms. However, Glowform Ltd
has only been in operation for just over a year and has, as yet, not been able to provide any
financial statements.
An example of a refusal letter:
SC FUEL AND GLASS
CRAWLEY RD
CRAWLEY
CR7 JN9
Tel: 01453 732166 Fax: 01453 732177
Finance Director
Glowform Ltd
Date:
Dear Sir
Re: Request for credit facilities
Thank you for your enquiry regarding the provision of credit facilities of £5,000 of credit on 60day terms. We have taken up your trade and bank references of which you kindly sent details.
We have some concerns about offering credit at this early stage of your business as there are as
yet no financial statements for your business that we can examine. Therefore, at this stage I am
unable to confirm that we can provide you with credit facilities immediately.
We would, of course, be delighted to trade with you on cash terms until we have had an
opportunity to examine your first year's trading figures. Therefore, please send us a copy of your
first year financial statements when they are available and, in the meantime, contact us if you
would like to start trading on a cash basis.
Thank you for your interest in our company.
Yours faithfully
Tom Hunt
Credit controller
Activity 10: Refusal of credit reasons
What potential reasons could there be for not agreeing to trade on credit with a new customer?
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Activity 11: Signs of overtrading
Required
Identify six signs that may indicate a business is overtrading.
6.5
The ethical principle of objectivity
The AAT Code of Professional Ethics defines objectivity as an obligation not to compromise
professional or business judgement because of bias, conflict of interest or undue influence of
others (Association of Accounting Technicians, 2017).
This means that the credit controller will need to reach credit assessment decisions using their
organisation's credit control policy and a customer's merit without any risk to objectivity.
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There are a number of potential threats to objectivity and these are:
Threat
Explanation
Example
Self-interest
Financial or other interests that may
influence a decision
A credit controller has shares in the
company requesting credit
Self-review
A previous decision re-evaluated by the
person responsible for the original
decision
A junior member of a credit control
team checking their own work instead
of a senior credit controller
Advocacy
A person promotes a decision to the
point that objectivity is compromised
Where a credit controller is biased in
advocating a specific credit assessment
decision
Familiarity
Due to a close personal relationship a
person becomes too sympathetic to the
interests of others
The spouse of a credit controller is the
managing director of a company
requesting credit
Intimidation
A person may be deterred from acting
objectively by threats (actual or
perceived)
A credit controller receiving rude and
threatening telephone calls from a
customer
Activity 12: Identification of threats to objectivity
A brother and sister work at the same company. The sister is a member of the sales team and the
brother is the company's credit controller. The brother is paid on a fixed salary basis and the
sister is remunerated on the value of sales made.
Required
What two threats to objectivity are most likely here for the management of credit?

Self-interest
Self-review
Advocacy
Familiarity
Intimidation
Assessment focus point
If you are requested to identify threats to ethics, then always explain why you are making
your choice or choices. For example, a task may ask how objectivity is threatened if sales
commissions are available on sales made on credit. Your answer can be framed along the lines
of the following: 'A threat to objectivity here can be the threat of self-interest. This is because
there is a financial incentive here to grant credit, even though normally a customer would not
be allowed credit'.
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Chapter summary
 When evaluating a customer's credit status, the concerns will be whether the customer will pay
within the stated credit terms and that the business will remain solvent.
 When either a potential new customer requests credit or an existing customer requests an
increase in credit limit, the credit controller will make use of internal and external information in
order to determine whether or not the request should be granted.
 External sources of information are most commonly a bank reference and two trade references.
 In some cases, a credit controller will use the services of a credit reference agency for information
about a potential customer and a possible credit rating or, rather more informally, from any
credit circle that they may belong to.
 Other sources of external information are financial statements, management accounts,
publications and the internet.
 When considering requests from existing customers, it is likely that staff within the business will
have internal information about the customer and may possibly have made visits to the
customer's premises.
 The most common form of internal analysis of both existing and potential new customers is
financial ratio analysis of their financial accounts, preferably for the last three years or more.
 Once all of the relevant information has been gathered about a customer, then a decision must
be made as to whether or not to grant them credit – in many cases, the information may be
conflicting, with some sources suggesting that credit should be granted and other sources not
proving so favourable.
 Credit scoring is a method used by organisations such as banks and utility companies to assess
the creditworthiness of an individual or organisation.
 Once a decision has been made as to whether or not to grant credit to a customer, this decision
must be communicated to the customer, normally in writing.
 Where credit is to be granted to a new customer, the details of the credit limit and terms of
payment must be made quite clear and a new account for that customer must be opened within
the trade receivables ledger.
 In some cases, it may be decided to refuse credit to a customer, in which case this must be
communicated in a tactful and diplomatic manner.
 In some cases, a customer may be offered a chance for future re-assessment of their credit
status; in the meantime, an offer for trading on cash terms would be made.
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Keywords

Bank reference: A bank's opinion of its customer's business position and credit status

Capital employed: Total equity + non-current liabilities

Credit application form: A form sent to a prospective new customer asking for details
including bank and trade reference details

Credit circles: Groups of companies which can provide mutual information on current and
prospective customers and their credit records

Credit reference agency: A commercial organisation providing background information
and credit status information about companies and individuals

Current ratio: Current assets compared to current liabilities expressed as a ratio

Gross profit margin: Measure of the profit from trading activities compared with revenue

Inventory holding period: The average number of days for which inventory is held

Net asset turnover: Measure of the amount of revenue compared with total capital
employed

Objectivity: A fundamental ethical principle that avoids bias, conflict of interest or undue
influence in decision making

Operating profit margin: Measure of the overall (operating) profit compared with revenue

Quick ratio/acid test ratio: Current assets minus inventory as a ratio to current liabilities

Return on capital employed (ROCE): Compares operating profit with capital employed

Trade payables payment period: How many days on average a business takes to pay its
trade payables

Trade receivables collection period: How many days on average it takes for receivables to
pay

Trade reference: A reference from one of a business's current suppliers regarding its
payment record

Working capital cycle: Inventory holding period (days) plus receivables collection period
(days) less payables period (days)
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Test your learning
1
You are the credit controller for AKA Ltd and you are considering a request from Kelvin &
Sons which wishes to trade on credit with your company. You are considering offering a
credit limit of £10,000 with terms of payment within 30 days of the invoice date.
You have written to Kelvin & Sons' bank, Southern Bank, asking for a reference, having
specified that you are considering a credit limit of £10,000. The bank's reply is given below.
'Should prove good for your figures'
What, if any, conclusions can you draw from the bank reference?
A
B
C
D
2
Credit should be granted
Credit should not be granted
Credit should be granted if further information is positive
No conclusion can be drawn
You are the credit controller for a company and you are considering a request from
Caterham Ltd which wishes to trade on credit with your company. Caterham Ltd asked for
a credit limit of £15,000, with terms of payment within 30 days of the invoice date. You
have a standard form for trade references and Caterham Ltd has provided you with the
name and address of another of its suppliers, SK Traders, to which you have sent the
standard trade reference form. The reply you receive is given below.
Trade reference
We have received a request for credit from Caterham Ltd which has quoted yourselves as a
referee. We would be grateful if you could answer the following questions and return this in
the stamped addressed envelope enclosed.
How long has the customer been trading
with you?
..4.. years . 2... mths
Your credit terms with customer per month
£ 8,000
Period of credit granted
.............. 30 days...............
Payment record
Prompt/ occasionally late /slow
Have you ever suspended credit
to the customer?
Yes/ No
If yes – when and for how long?................................................................
Any other relevant information ...................................................................
...............................................................................................................
Thank you for your assistance.
What, if any, conclusions could you draw from the trade reference?
3
What services does a credit reference agency typically provide?
4
Which of the following information could be provided by Companies House about a
company that was requesting credit from your business?
A
B
C
D
Management accounts
Directors' contracts
Annual financial statements
Loan agreements
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5
You are the credit controller for a business and you have been approached by Franklin Ltd,
which wishes to place an order with your business and to trade on credit. It would like a
credit limit of £5,000 per month. Franklin Ltd has provided you with its last two years'
statements of profit or loss and statements of financial position.
Statements of profit or loss for the year ended 31 March
Revenue
20X9
£000
20X8
£000
1,000
940
Cost of sales
(780)
(740)
Gross profit
220
200
Operating expenses
(100)
(90)
Operating profit
120
110
Interest payable
(30)
(20)
Profit before tax
90
90
Taxation
(23)
(43)
67
47
20X9
£000
20X8
£000
1,335
1,199
Inventory
110
90
Receivables
140
150
250
240
1,585
1,439
Share capital
800
800
Retained earnings
325
278
1,125
1,078
Trade payables
160
161
Bank overdraft
300
200
Total liabilities
460
361
1,585
1,439
Profit after tax
Statements of financial position at 31 March
Assets
Non-current assets
Current assets
Total assets
Equity and liabilities
Equity
Total equity
Current liabilities
Total equity and liabilities
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Complete the table below by calculating the ratios given (to 2dp).
20X9
20X8
Gross profit margin (%)
Operating profit margin (%)
Current ratio
Quick ratio
Trade payables payment period (days)
Interest cover (times)
6
You are the credit manager for Acorn Enterprises and your name is Jo Wilkie. You have
been assessing the financial statements for Little Partners, which has requested £8,000 of
credit on 60-day terms. You also have received a satisfactory bank reference and trade
references.
Your analysis of the 20X7 and 20X8 financial statements shows the following picture:
20X8
20X7
Operating profit margin
10%
5%
Gearing
66%
70%
Interest cover
1.5 times
0.9 times
Current ratio
1.3 times
0.8 times
You are to draft a suitable letter to Little Partners, dealing with its request for credit
facilities.
7
You are the credit controller for a business and you received a request from
Dawn Ltd for credit of £5,000 from your company on a 30-day basis. Two trade references
have been provided, but no bank reference. You have also been provided with the last set
of published financial statements, which include the previous year's comparative figures.
The trade references appeared satisfactory – although one is from Johannesson Partners
and it has been noted that the managing director of Dawn Ltd is Mr F Johannesson.
Analysis of the financial statements has indicated a decrease in profitability during the last
year, a high level of gearing and low liquidity ratios.
Draft a letter to the finance director of Dawn Ltd on the basis that credit is to be
currently refused, but may be extended once the most recent financial statements
have been examined.
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Legislation and
credit control
Syllabus learning outcomes/objectives
1.1
Statute and contract law applicable to credit control
Learners need to understand:
1.2

Essential features and terminology of contract law: offer (includes invitation to
treat and counter offer), acceptance, consideration (sufficiency, adequacy and
past), intention to create legal relations, capacity and consent

Legislation relating to: trade descriptions, unfair contract terms, the sale and
supply of goods and services and consumer credit
Breach of contract and the circumstances in which they can be used
effectively
Learners need to understand:

Key considerations for breach of contract: express terms, implied terms,
conditions, warranties, damages, specific performance, quantum meruit and
action for the price

Statutory remedies for late payments of commercial debts (interest)

Remedies available for collection of outstanding amounts
Learners need to be able to:

1.3
Calculate interest and/or compensation due on overdue debts using statutory
remedy for late payments of commercial debts
Terms and conditions associated with customer contracts
Learners need to understand:


1.4
Void, voidable and unenforceable contracts
Retention of title clauses
Data protection and ethical considerations associated with credit control
activities
Learners need to understand:



The legislation relating to data protection
The effect of data protection on the organisation and its customers
Professional ethics in the context of credit control
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4.1
Legal and administrative procedures for debt collection
Learners need to understand:





4.2
The retention of title clause (basic and all monies)
The conditions required for retention of title clauses to be effective
The use of small claims, fast-track and multi-track court processes
Garnishee orders, warrants of execution and delivery
Attachment of earnings and charging orders
Insolvency
Learners need to understand:

Advantages and disadvantages of initiating: liquidation, compulsory and
voluntary, receivership, administration, individual bankruptcy and Company
Voluntary Arrangement (CVA)

Processes to follow in the event of initiating: liquidation, receivership,
administration, individual bankruptcy and CVA
Assessment context
Credit and Debt Management students must be able to explain the main features of contract law
and be able to identify appropriate remedies for any breach of contract when things go wrong.
Additionally, students need to be aware of other relevant legislation, such as consumer rights,
along with data protection legislation.
Qualification context
Contract law was introduced at Level 2 in the Business Environment unit and data protection is
expanded upon from the Business Awareness unit at Level 3.
Business context
Contract law is an important area within credit and debt management. It helps to prevent
misunderstandings between all parties to a transaction and provides remedies if one party does
not fulfil their contracted responsibilities. In the context of credit control, this means that debts
are collected from customers when due.
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Chapter overview
Other legislation
Types of
court

High court

County court

Late Payment of Commercial Debts
(Interest) Act

The Data Protection Act
Legislation and
credit control
Bankruptcy and
insolvency
Contract law
Distribution of
assets
Breach of contract
Remedies for breach
of contract

Action for the price

Monetary damages

Specific performance

Quantum meruit
Methods of receiving
payment

Attachment of earnings

Garnishee order

Receiver

Charge

Bankruptcy

Insolvency

Warrant of execution
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Introduction
Legislation is an important area in credit management as it governs how contracts between
parties are enforced.
In this chapter, we are going to look at contract law and legal definitions, along with the remedies
a party may have if one party does not fulfil its part of a contract.
We will also cover bankruptcy for individuals, sole traders and partnerships, along with
liquidation or administration for companies.
Other legislation can be important; these include the Data Protection Act and the Late Payment
of Commercial Debts (Interest) Act.
1 Contract law
The relationship between a seller of goods and a buyer of goods is a contract, therefore in this
section we must consider the basics of contract law.
1.1
What is a contract?
A contract may be defined as a legally enforceable agreement between two or more parties.
As an individual, you will enter into contracts every day – when you buy goods in a shop, when
you place an order for goods over the internet, when you employ a plumber to fix a leak. These
contracts may be verbal, but they can also be in writing: for example, if you take out a loan from
your bank, there will be a written contract.
During your working hours, you will also be part of the process of contracts being made between
your organisation and its customers and suppliers.
Contracts have three main elements, and these are: agreement, consideration and intention to
create legal relations.
1.2
The importance of contract law
The importance of contract law is that if a contract is validly made between two parties, and if
one party does not satisfactorily carry out its side of the agreement, the other party can take the
defaulting party to court for breach of contract.
1.3
How is a contract formed?
For a contract to be formed and to be valid, there must be three main elements:
Agreement + Consideration + Intention to create legal relations = Contract
1.4
Agreement
In legal terms, for there to be a valid agreement there must be a valid offer and a valid
acceptance of that offer.
There will be two parties to a contract – the offeror and the offeree.
Offeror – the person making the offer.
Offeree – the person to whom the offer is made.
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Illustration 1
The glass division of SC Fuel and Glass has received a purchase enquiry from a large building
contractor concerning the purchase of 1,000 sealed glazed units. For such a large order, the
glass division is prepared to reduce the price charged from the normal price of £80 to £78 per
unit, and has sent out a purchase quotation stating this price for the 1,000 units.
Required
Who is the offeror and offeree?
This will become a valid offer from SC Fuel and Glass to the building contractor when the building
contractor receives the purchase quotation. Obviously, it is important that the price quoted is
correct as, if not, the building contractor could legally require SC to sell the units to it at the price
quoted.
Remember also that an offer can be made verbally, so if quoting a price to a customer over the
telephone, ensure that it is the correct price as it will be a valid offer.
The building contractor will become the offeree if it wishes to take up SC Fuel and Glass's offer.
Activity 1: Offeror and offeree
A newsagent is open for business when a customer enters, picks up a magazine and pays the
shop owner.
Required
Who is the offeror and offeree in this situation?
1.5
An invitation to treat
Care must be taken to distinguish between an offer and an invitation to treat. An invitation to
treat is an invitation by the seller of goods for the buyer to make an offer to buy them at that
price. Examples of invitations to treat are advertisements for goods, catalogues and price tickets
displayed on goods.
Illustration 2
The glass division of SC Fuel and Glass issues a catalogue to potential and existing customers
twice a year, showing the different types of double-glazed units available and their prices.
Required
Is this an offer or an invitation to treat?
This is an invitation to treat and not an offer, therefore SC is not necessarily tied to the prices
quoted in the catalogue. If a customer enquires about purchasing goods from the catalogue,
then they are making an offer to buy the goods at the catalogue price. It is then up to SC to
decide whether or not to accept this offer by selling to the customer at the published price – or
changing the price if circumstances have changed.
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Activity 2: Invitation to treat or an offer?
It is a rainy afternoon and a goods shop has a stand of umbrellas outside, all priced for sale at
£2.99 each.
Required
Is this an example of an invitation to treat or an offer?
Activity 3: Pricing error
Jon is in a car showroom and sees a price ticket on a car of £2,395. He offers to buy the car at
this price but is informed by the salesperson that there was an error on the price ticket, which
should have read £12,395.
Required
Explain whether Jon can insist on purchasing the car at £2,395.
1.6
Duration of an offer
If an offer is made, then it does not have to remain in place indefinitely. There are a number of
ways in which an offer can be brought to an end:
(a)
If there is a set time period for an offer, then the offer will lapse at the end of that time
period. If there is no express time period set, then the offer will lapse after a reasonable
period of time.
(b)
An offer can be revoked by the offeror at any point in time before it has been accepted.
Revocation of an offer means that the offer is cancelled.
(c)
An offer comes to an end if it is rejected. Care must be taken here, as rejection need not
only be by the offeree specifically saying 'no' to the offer. An offer is also rejected by a
counter-offer. For example, if an offer is made to sell an item for £1,000 and the offeree
replies to say that they will buy it at a price of £900, this is a rejection of the original offer
to sell.
(d)
The offer also comes to an end when a valid acceptance is made.
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1.7
Acceptance of an offer
The acceptance of an offer must be an absolute and unqualified acceptance.
(a)
Acceptance can be made verbally or in writing.
(b)
If an offer requires a particular form of acceptance (such as verbal, in writing or by fax),
then this is the form in which the acceptance must be made.
(c)
The acceptance must be unqualified – if any additional conditions or terms are included in
an acceptance, then this takes the form of a counter-offer, which rejects the original offer.
Activity 4: Changes to an offer
A homeowner has instructed a builder to construct a brick wall in their garden. A contract has
been agreed and a payment made to cover the costs of materials. Part way through the work,
the homeowner requests that the wall is to be decorated with expensive decorative bricks.
Required
Explain how this affects the contract between the homeowner and builder.
1.8
Consideration
The second required element of a contract is consideration. This means that both parties must
bring something of value to the agreement. Consideration can be thought of as something given,
promised or done in exchange for the action of the other party. Consideration can be something
of money's worth; for example, you could give your pen for someone's car in return.
To be valid, consideration must be provided at the time the contract is formed or at some point
afterwards.
Consideration provided before the contract is formed is known as past consideration and is not
valid. For example, if a person offers to sell their friend their laptop and the friend had painted
their fence a week ago, the fence painting cannot be used as consideration for the laptop.
In terms of business transactions, the consideration given for a sale of goods is either the money
paid now or the promise to pay at a later date.
Note that consideration does not have to be of equal value or reflect market value. The general
rule to remember is that consideration must be sufficient, but it need not be adequate. In other
words, it just needs to have some value, even if this is substantially more or less than what the
other party is bringing to the contract. There is no remedy in law for a bad bargain!
Activity 5: Essentials of a valid contract
A cyclist has a puncture and has taken their bike into a cycling shop for repair. The shop owner
has stated that, as they have some spare time, they would be happy to repair the tyre free of
charge.
Required
Explain whether there is a valid contract between the cyclist and shop owner.
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1.9
Diagram of a valid contract
Tomahawk Telecom Ltd (TT Ltd) has a high street shop that sells mobile telephones. TT Ltd
publishes a regular brochure that gives details of telephones for sale and their prices. TT Ltd's
brochure is an invitation to treat.
TT Ltd
Brochure
Invitation to t reat
General
public
If a customer contacts the shop to purchase a telephone out of the brochure, then this is an offer
at the price given in the brochure for the telephone. The customer is the offeror.
TT Ltd
A customer offers
to purchase a telephone
Customer
Offeror
TT Ltd now has the option to accept this offer. TT Ltd is the offeree as it is the party to which the
offer is made.
TT Ltd
Offeree
TT Ltd accepts the
customers offer
Acceptance of offer
Customer
Offeror
Value has to pass between offeror and offeree so that there is a valid contract. This is called
consideration. In this example the consideration is the mobile telephone and money exchanging
between TT Ltd and the customer.
Money
TT Ltd
Offeree
Telephone
Customer
Offeror
Consideration
1.10
Unilateral contracts
Most contracts are known as bilateral contracts, meaning that two persons or parties have taken
action to form a contract. Unilateral contracts involve an action undertaken by one person or
group alone. In contract law, unilateral contracts allow only one person to make a promise or
agreement, so only they are under an enforceable obligation.
A common example of a unilateral contract is with insurance contracts. The insurance company
promises it will pay the insured person a specific amount of money if a certain event happens. If
the event doesn't happen, the company won't have to pay. The insured party doesn't make any
promise and, to keep their part of the deal, only needs to pay the insurance premium.
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1.11
Defective contracts
There are some situations in which a contract will only have limited legal effect – or even no legal
effect at all.
A void contract is not a contract at all. The parties are not bound by it and if they transfer
property under it, they can sometimes recover their goods – even from a third party. This
normally comes about due to some form of common mistake on a fundamental issue of the
contract.
A voidable contract is a contract which one party may set aside. Property transferred before the
contract is voided is usually irrecoverable from a third party. Such contracts may be with minors,
or contracts induced by misrepresentation, duress or undue influence.
In these cases, it can be deemed that a party did not have the legal capacity to consent to a
contract. Examples here can be intoxication, mental health or being too young to enter into a
contract. Contracts can also be voidable due to coercion; this is where one party to the contract
may be using threatening behaviour towards the other party.
An unenforceable contract is a valid contract; property transferred under it cannot be recovered,
even from the other party to the contract. But if either party refuses to perform or to complete
their part of the performance of the contract, the other party cannot compel them to do so. A
contract is usually unenforceable when the required evidence of its terms, for example, written
evidence of a contract relating to land, is not available.
2 Breach of contract
Parties to a contract can take the other to court for breach of contract. Breach of contract is
where one party to the contract does not fulfil their part of the agreement.
2.1
Terms in a contract
In most contracts there are certain terms that must be fulfilled in order for the contract to be
carried out. If the terms of a contract are not fulfilled, then one party will be in breach of
contract. Legally, different terms of a contract have different effects.
Express terms are terms that are specifically stated in the contract and are binding on both
parties.
Implied terms are terms of a contract which are not specifically stated but are implied in such a
contract, either by trade custom or by the law.
Express and implied terms refer to how terms can be included into a contract. Once in a contract,
terms are usually one of the following two types.
Conditions are terms that are fundamental to the contract and, if they are broken, then the party
breaking them will be in breach of contract and can be sued for damages. The injured party can
regard the contract as ended.
Warranties are less important terms in a contract. If any of these are not fulfilled, then there is
breach of contract but the contract remains in force. The injured party can still claim damages
from the court for any loss suffered, but they cannot treat the contract as terminated.
Terms can also be a third type, innominate. This means that, due to their nature, it is not clear
whether they are a condition or warranty until they are broken. A court will usually determine
what they are.
2.2
Remedies for breach of contract
A breach of contract arises where one party to the contract does not carry out their side of the
bargain, such as a credit customer who does not pay. There are a number of remedies available
to the injured party for breach of contract.
These include:

Action for the price – a court action to recover the agreed price of the goods/services
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
Monetary damages – compensation for loss

Termination – one party refusing to carry on with the contract

Specific performance – a court order that one of the parties must fulfil its obligations

Quantum meruit – payment ordered for the part of the contract performed

Injunction – one party to the contract being ordered by the court not to do something
In terms of a credit customer not having paid for goods or services provided, the most
appropriate remedy would normally be an action for the price.
Assessment focus point
In the assessment, you may have to suggest an appropriate remedy for a breach of contract.
If this is asked for, you should take into account all available information and look for the best
outcome to the injured party. Normally, action for the price will give a better outcome for the
seller compared to monetary damages, as the full selling price can be recovered.
Activity 6: Remedy for breach of contract (1)
A trader has sold and delivered goods to a credit customer; however, the customer is now refusing
to pay for the goods. The goods originally cost the trader £60 and the selling price to the
customer was £100.
Required
Identify the most appropriate remedy available to the trader.
Activity 7: Remedy for breach of contract (2)
A gardener has entered into a contract with a land owner to cut six trees. After three trees have
been cut, the land owner states they have changed their mind and now wishes to cancel the
work.
Required
Identify the most appropriate remedy for the gardener to recover payment.
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2.3
Restitutionary and compensatory damages
Restitutionary damages aim to strip, from a wrongdoer, any gains made by committing a wrong
or breaching a contract. They are concerned with the reversal of benefits that have been earned
unjustly by the defendant at the expense of the claimant.
A real-life example of restitutionary damages is the British spy who, as part of their contract of
employment, had signed the Official Secrets Act. The spy later breached their contract by
divulging state secrets in their memoirs. The British Government duly sued the spy for the profits
made on their book.
If the monetary remedy or damages is to be the loss made by the claimant, these are known as
compensatory damages, and are intended to provide the claimant with the monetary amount
necessary to replace what was lost and nothing more. Common examples of compensatory
damages are lost wages or income.
2.4
Bringing a dispute to court
If it is decided that the only course of action to recover money owed by a credit customer is that
of legal action, then the first step is to instruct a solicitor. The solicitor will require details of the
goods or services provided, the date the liability arose, the exact name and trading status of the
customer, any background information (such as disputes in the past) and a copy of any invoices
that are unpaid.
Assessment focus point
When considering court action, bear in mind that it may not be viable to bring a customer to
court for outstanding debts. The use of a solicitor can be expensive and the court process time
consuming. If the debt is a small amount and/or if there is some doubt the customer can pay
then it may, in some circumstances, be appropriate to write the amount off as irrecoverable.
2.5
Which court?
Outstanding amounts owed to an entity are civil claims.
Uncomplicated claims with a value under £10,000 will be dealt with in the County Court under
the Small Claims Track (sometimes known to the lay public as 'Small Claims Court' although it is
not a separate court).
Claims between £10,000 and £25,000 that are capable of being tried within one day are
allocated to the 'fast track'.
Claims over £25,000, or very complex cases where the amount is less than £25,000 but will
require more than one day in court, are allocated to the 'multi-track' route.
Most cases will be heard in the County Court, but very complex or high-value cases will be heard
by the High Court. A judge will decide if the case will be dealt with in a 'fast track' or 'multi-track'
hearing once initial paperwork has been filed by the claimant and the defendant.
Hierarchy of civil courts
High Court
Multi-track - for complex cases
Claims over £25,000
County Court
Fast-track - one day cases
Claims between £10,000 and £25,000
County Court
Small claims track
Claims less than £10,000
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Activity 8: Type of court
An action is to be brought against a customer for unpaid amounts totalling £5,000.
Required
In which court would this action normally be brought?

County Court
Magistrates' Court
High Court
Crown Court
2.6
Methods of receiving payment under a court order
Once there has been a court order that the money due must be paid, there are a number of
methods of achieving this:
Attachment of earnings order
The business will be paid the amount owing directly by
the customer's employer, as a certain amount is
deducted from their weekly/monthly pay. However, this
is only viable for a customer who is an individual and is
in stable, consistent work.
Third-party debt order
(garnishee order)
This allows the business to be paid directly by a third
party who owes the business's customer money.
Warrant of execution
A court bailiff seizes and sells the customer's goods on
behalf of the business. Similar to a bailiff is where a
sheriff is authorised by a court to seize assets of a
customer in settlement of a debt.
Administrative order
The customer makes regular, agreed payments into
court to pay off the debt.
Receiver
A receiver is appointed to receive money that will be
owing to the customer, eg rents.
Charging order
A legal charge is taken on property or financial assets,
so the supplier is paid when the assets are sold.
Bankruptcy
See next section.
Liquidation
See next section.
Illustration 3
SC Fuel and Glass is owed £2,800 by one of its hauliers, Terence Frame & Sons. The claim was
taken to the Small Claims Court and SC Fuel and Glass was successful in its claim against
Terence Frame & Sons. During the case, it becomes apparent that a third party, Cranford
Garages Ltd, owed Terence Frame & Sons £4,000. To date, Terence Frame & Sons has had a very
poor record in paying its suppliers.
What arrangement would be most suitable here for SC Fuel and Glass to receive payment?
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Conclusion: The most appropriate arrangement here would be for the court to order the third
party, Cranford Garages Ltd, to pay £2,800 direct to SC Fuel and Glass and then for Cranford
Garages Ltd to pay the balance of £1,200 to Terence Frame & Sons. This type of third-party debt
order is sometimes referred to as a garnishee order.
Activity 9: Method to receive payment
A customer owes a business £2,000. The customer does not have an income but does own two
top-of-the-range laptops. The business intends to take legal action against the customer.
Required
Identify the most appropriate method of payment that the court could award the business.
Assessment focus point
If you are required to suggest a method to receive payment, always take into account any
information supplied. Is the customer in employment to make payments from – or do they
have any assets of value that could be sold?
3 Bankruptcy and insolvency
Bankruptcy arises where an individual cannot pay their debts and is declared bankrupt.
Insolvency is where a company cannot pay its debts as they fall due.
3.1
Petition for bankruptcy
If a customer (who is an individual) owes an amount of at least £5,000, a statutory demand can
be issued for payment of the amount due within a certain period of time. This may result in the
customer offering a settlement. If, however, there is no settlement offer from the customer, a
petition for bankruptcy will be received from the court.
Once the individual has received the statutory demand, they have 21 days, either to pay the debt
or reach an agreement to settle the outstanding amount.
There are time limits in making a statutory demand and these are:
3.2
(a)
The demand should be made within four months of the debt. If the debt is older than four
months, a court has to be contacted to explain the reasons behind the delay.
(b)
Normally, a statutory demand cannot be made after six years have elapsed.
Consequences of a petition for bankruptcy
The consequences of a petition for bankruptcy against a customer are:

If the customer pays money to any other suppliers or disposes of any property, then these
transactions are void.

Any other legal proceedings relating to the customer's property or debts are suspended.

An interim receiver is appointed to protect the estate.
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3.3
Consequences of a bankruptcy order
The consequences of a bankruptcy order are:
3.4

The official receiver takes control of assets.

A statement of the assets and liabilities is drawn up – this is known as a statement of
affairs.

The receiver summons a meeting of creditors of the individual within 12 weeks of the
bankruptcy order.

The creditors of the individual appoint a trustee in bankruptcy.

The assets are realised and a distribution is made to the various creditors.

The creditor who presented the petition does not gain any priority for payment over other
creditors.
Order of distribution of assets
The assets of the bankrupt will be distributed in the following order:







Secured creditors
Bankruptcy costs
Pre-preferential debts, such as funeral expenses if the bankrupt is deceased
Preferential creditors such as employees, pension schemes, HM Revenue & Customs
Unsecured creditors, such as trade payables
Postponed debts, such as those owing to the bankrupt's spouse
The bankrupt
As an unsecured trade creditor, a business with debts due from a bankrupt should submit a
written claim to the trustee detailing how the debt is made up. This may also need to be
substantiated with documentary evidence. As the payment of unsecured creditors comes after
many other payments, the supplier may receive little or nothing towards the amount owed. Often
this is in the form of a 'dividend': for example, if a bankrupt owed £100,000 to creditors, but has
only £20,000 left after other payments have been made, then a creditor will only receive 20
pence for every pound that it is owed.
Activity 10: Bankruptcy an option?
Haven Limited is one of your firm's clients and is currently facing financial difficulties. The
managing director of the company has expressed an opinion that the company will eventually go
bankrupt.
Required
Explain how you would respond to the managing director’s statement.
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3.5
Insolvency
The process of insolvency for a company that cannot pay its debts as they fall due is similar to
that of a bankrupt individual. There are two main options for companies:


3.6
Liquidation
Administration
Liquidation
In a liquidation, the company is dissolved and the assets are realised, with debts being paid from
the proceeds and any excess being returned to the shareholders. This process is carried out by a
liquidator on behalf of the shareholders and/or creditors. The liquidator's job is simply to ensure
that the creditors are paid and once this is done, the company can be wound up. Again,
unsecured creditors are a long way down the list of who is paid first, therefore there may be little
left in the pot.
Assessment focus point
Keep in mind that the responsibility of the liquidator is to identify any assets of the troubled
company and then distribute to the outstanding creditors, so that the company's debts can
be paid as fully as possible. Although the liquidator will act professionally and with fairness
towards the company, it is not their role to save the company.
It can be the case that it is not possible to receive full payment from the liquidator. In these
situations, a distribution of an amount per pound owed will be paid. For example, if a business
is owed £2,000 and 5p in the pound is to be settled, then £100 (£2,000  0.05) will be
distributed by the liquidator on behalf of the debtor. Ignoring any VAT considerations, the
company would need to write off the balance of £1,900 as irrecoverable.
3.7
Administration
An alternative to a liquidation is that the shareholders, directors or creditors can present a
petition to the court for an administration order. The effect of this is that the company continues
to operate but an insolvency practitioner (administrator) is put in control of it, with the purpose of
trying to save the company from insolvency, as a going concern – or at least achieve a better
result than a liquidation.
Administrative receivership is a process whereby a creditor can enforce security against a
company's assets in an effort to obtain repayment of the secured debt. It used to be the most
popular method of obtaining payment by secured creditors, but legislative reforms have reduced
its significance.
Administrative receivership differs from liquidation in that an administrative receiver is appointed
over all of the assets and undertakings of the company. This means that an administrative
receiver can normally only be appointed by the holder of a floating charge. Usually, an
administrative receiver will be an accountant with considerable experience of insolvency matters.
3.8
Retention of title clause
A 'retention of title' clause can be written into agreements with customers. A basic clause states
that the buyer does not obtain ownership of the goods sold within a particular order unless and
until payment for them is made. Such clauses often state that the seller has the right to enter the
buyer's premises to recover the goods if they are not paid for.
An all monies clause has the same effect as a basic clause, but states that the buyer does not
obtain ownership in all goods sold until all outstanding invoices are paid. They are useful because
the seller does not need to identify unpaid invoices with specific goods to recover them.
Either clause means that if the buyer goes out of business before paying for the goods, or refuses
to pay for them, the supplier can retrieve them. If appropriate, goods can also be stopped in
transit.
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However, there are circumstances where they may not be effective. For example:

Where the goods are immediately re-sold by the customer (unless there is a specific clause
covering goods for resale)

Where the goods are perishable (for example, soft fruit and flowers) because the goods are
likely to have perished by the time the clause is activated

Where the clause is not properly incorporated into the contract

Where the customer is in administration (see later) the seller cannot recover the goods
without the permission of the administrator
In an insolvency situation (see later), if an official receiver sells goods that are subject to a valid
retention of title clause, then the supplier can sue the official receiver for damages, as ownership
of the goods still belong to the supplier.
Assessment focus point
Look out for use of retention of title clauses in the assessment. The key here is who actually
own the goods. These types of clauses included into contracts stipulate the ownership of (or
title to) the goods remains with the seller until the buyer actually makes payment. Problems
can arise, though, when it is difficult to identify the goods delivered (for example coal), if the
goods have since been modified, or if the 'buyer' has since sold the goods on. This is where the
courts can be needed in making a final decision.
Activity 11: Bankruptcy and insolvency
Required
Outline the main differences between bankruptcy and insolvency.
Bankruptcy
Insolvency
4 Other legislation
4.1
Trade Descriptions Act 1968
The Trade Descriptions Act 1968 (HMSO, 1968) makes it a criminal offence to declare false or
misleading statements about goods being sold or services being provided.
For example, if a business stated that a particular product was now being sold for £24.99,
reduced from £49.99, this would be a criminal offence if, in fact, the product had previously been
sold at a price of £39.99. (Trade Descriptions Act 1968.)
4.2
Consumer Rights Act 2015
The purpose of the Consumer Rights Act 2015 (TSO, 2015) is to protect the rights of consumers
when entering into contracts for the supply of goods, services and also supplies of digital
content. Digital content can include such items as e-book, and music downloads.
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The Act states that there are three key necessities for the goods. They must be:

'Of satisfactory quality' – this is the standard of quality that a reasonable person would
expect, given the description of the goods and their price

'Fit for purpose' – the goods should do what they would be expected to do or what the
shop claims they can do

'As described' – the goods must be what they are described to be; for example, an
automatic car must have an automatic gearbox
Where goods are sold on credit, title of ownership passes when goods are ready for delivery. For
goods sold by ‘sale or return,’ title passes when the buyer approves the goods (eg does not reject
them).
The Act outlines specific rights for consumers. These rights include the following:

The right to pre-contract information before a purchase is made.

Goods supplied have to match any samples shown before a purchase is made.

A right to a repair or replacement if goods do not match those described.

If goods supplied do not match those agreed to, the consumer has a 'short-term right to
reject' with a time limit of 30 days – with a final right to reject if the goods still do not
match those described.

If a refund is given to the consumer, then no deductions are allowed from the amount
repaid.
The Act also requires that contract terms and notices need to be fair, to help ensure that any
unfair terms or notices are not included in the 'small print'.
A term or notice can be deemed unfair when it causes a significant inequality to the detriment of
the consumer.
Terms or notices that are unfair are not binding on the consumer; however, consumers can still
agree to such terms if they so wish.
4.3
Consumer Credit Act 2006
The Consumer Credit Act 2006 (HMSO, 2006) gives additional rights to individuals (rather than
companies) who are credit customers of a business. The aim of the Act is to ensure that
individuals who become credit customers of a business are fully aware of what they have agreed
to.
4.4
Late Payment of Commercial Debts (Interest) Act 1998
The Late Payment of Commercial Debts (Interest) Act 1998 (HMSO, 1998) gives businesses and
public sector bodies the right to claim interest from business customers or public sector customers
which pay late. It is for the supplier to decide whether or not to make a claim for interest.
The statutory interest rate chargeable is the Bank of England base rate plus 8%. This was set so
that businesses could cover late payments by bank borrowings. Interest runs from the day after
the credit period if the customer has not paid within the agreed credit period. If there is no agreed
credit period, the legislation sets a default credit period of 30 days, after which interest can run.
The interest can be calculated using the following formula:
Formula to learn
Gross debt  (Bank of England base rate + 8%)  (number of days late/365)
Note. The 8% stated above is a HMRC statutory rate and can be subject to change, so always
read tasks carefully.
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Once statutory interest runs on a qualifying debt, the supplier is also entitled under the legislation
to claim a fixed sum for compensation as follows:



For debts less than £1,000, the supplier can claim £40.
For debts between £1,000 and £9,999.99, the supplier can claim £70.
For debts of £10,000 or more, the supplier can claim £100.
Illustration 4
SC Fuel and Glass is owed an amount of £10,000 plus VAT at 20%. The Bank of England rate is
2% and the debt is 60 days late.
The amount of interest due is £10,000  1.2  0.10  60/365 = 197.26.
(Late Payment of Commercial Debts (Interest) Act 1998.)
Activity 12: Late payment interest
Ajax Alloys Ltd is owed £12,000 plus VAT at 20% from Gable Garage Ltd. The Bank of England
rate is 1% and the debt is 40 days late.
Required
Calculate the interest Ajax Alloys Ltd can claim from Gable Garage Ltd under the Late Payment
of Commercial Debts (Interest) Act.
5 Data protection
Due to the growth in the use of computer technology, the Data Protection Act 2018 (TSO, 2018)
was introduced to restrict the use of data held about individuals and the use of personal data.
The principles of the Act apply to organisations which are collecting or holding information about
individuals. As it is likely that organisations which have a credit control department will be
processing information on individuals, ie their customers, it is important that the requirements of
the Act are complied with for these organisations.
One of the requirements of the Act is that every organisation that processes personal information
must notify the Information Commissioner's Office (ICO). Organisations must also notify the ICO
if there is a breach of data protection.
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It is important to realise that the Act only relates to personal information data held about
individuals and not about organisations, so will only be relevant to non-corporate customers or to
data about individuals who belong to a customer organisation.
Within each organisation, there must be a person who has the responsibility of informing the ICO
of ongoing information processing or changes. This is the role of the data controller. Once the
organisation is registered with the ICO, individual employees do not need to register, as they will
be covered by their organisation's registration. Of course, if the organisation consists of a sole
trader, then that person will need to register on their own behalf!
Failure to notify the ICO is a criminal offence. The ICO can issue very substantial fines for serious
breaches of the Act, so it is essential that organisations are aware of their responsibilities and
stay within the law. The ICO continually monitors organisations for any non-compliance of the
Act and, as you can see, the penalties can be severe – along with the negative publicity that can
surround an enforcement case.
5.1
Definitions from the Act
Personal information, any information held about a living individual who can be identified
(directly or indirectly) from it. It therefore includes not only factual information, but also
expressions of opinion about that individual.
A data subject is an individual who is the subject of personal data.
A data controller is a person who holds, controls and processes personal information.
5.2
Seven general principles of good practice
Principles
Explanation
Lawfulness, fairness and transparency
Data can only be held if there are valid grounds to do
so.
It can only be used fairly and with clarity, openness
and honesty in how the data is used from the start.
Purpose limitation
Individuals must be made aware of the purpose for
recording the data when it is first collected and again
if the purpose changes.
The purpose must be specified, explicit and legitimate.
Data minimisation
Data held must be adequate (sufficient to fulfil the
purpose), relevant (connected to the purpose for
holding it) and not excessive (the minimum needed to
fulfil the purpose).
Accuracy
Data held must be accurate and not misleading.
Reasonable steps should be taken to ensure there are
no inaccuracies.
Inaccurate or misleading data must be corrected.
Storage limitation
Data must not be held for longer than is needed for the
purpose it was collected and processed.
Data that is not needed must be deleted or
anonymised.
Integrity and confidentiality (security)
Appropriate security measures regarding the risks that
might arise in connection with the data must be taken.
Accountability
Taking responsibility for how personal data is used
and for compliance with the other principles.
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5.3
Data subject's rights under the Act
Data subjects have eight rights under the Data Protection Act.
Rights
Explanation
To be informed
Individuals must be informed about how their personal data
is collected and used.
Access
Individuals have the right to request information that is held
about them.
The requested information must be supplied within one
month and be free of charge.
Rectification
Individuals can request inaccurate, incomplete or misleading
information held about them to be rectified.
Erasure
This is known as the right ‘to be forgotten’. In certain
circumstances, individuals may request information held
about them be destroyed.
Restrict processing
In certain circumstances, individuals can have restrictions
placed on the processing of their data or have it suppressed
altogether.
The data can still be held, but it must not be processed.
Data portability
Individuals can request to be sent the data held about them
so they can reuse it in a different service.
For example, data held by an online banking app can be
requested and transferred to another app that can make use
of it (such as a money manager type app).
To object
Individuals can object to the processing of their data.
Where the data is used in connection with direct marketing,
there is an absolute right to object.
Where the data is used for other purposes, this right can be
refused if there is a compelling reason to do so.
Automated decision making and
profiling
Other data protection rights are granted to individuals where
data held about them is used to make automated decisions
or is otherwise evaluated.
For example, where decisions are made by bank computer
systems as to whether or not to lend money to an individual.
Individuals have the right to request human intervention or to
challenge decisions made following such processing.
For further information on the Data Protection Act please visit http://ico.org.uk.
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Activity 13: Customer information
You are a member of a credit control team where the customers are members of the public. A
colleague has stated that, as customer information is held in a paper format, it is acceptable to
hold excessive and sometimes non-relevant information on customers.
Required
Explain how you should respond to your colleague.
5.4
Professional ethics and credit control
The Data Protection Act outlines the legal responsibilities when holding data on individuals, but
there is an ethical responsibility to look after data and information properly. The fundamental
ethical principle most applicable here is confidentiality, whereby users of information should keep
information private and confidential. This is of particular importance when a business holds
sensitive information on its customers. For example, this can include names, addresses and bank
details.
There can be some instances where confidentiality can be breached and disclosure made. These
are:



When the customer provides permission to release information
Where there is a legal requirement to disclose
Where the disclosure is in the public interest
If customer information is not looked after as expected, then this can be seen as a breach of the
fundamental ethical principle of professional behaviour and can damage the reputation of the
business.
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Chapter summary
 A contract is a legally binding agreement, enforceable in a court of law.
 For a valid contract to exist, there must be agreement, consideration and an intention to create
legal relations.
 For an agreement to exist, there must be a valid offer and acceptance.
 An invitation to treat is an invitation to make an offer – advertisements, catalogues and price
labels in shops are examples.
 An offer may lapse, be revoked, be rejected, be rejected by a counter-offer or accepted.
 Acceptance may be verbal or in writing.
 The acceptance must be unqualified – if a qualification or an additional term is introduced, then
this is deemed to be a counter-offer and the original offer is, therefore, rejected.
 A valid agreement must also be supported by consideration – the consideration must be sufficient
but it need not be adequate.
 For an agreement to be enforceable in law, there must have been an intention to create legal
relations when the contract was made.
 If any terms of a contract are not fulfilled, then the injured party can sue for damages for breach
of contract.
 An agreement between a seller and a buyer of goods/services will normally be a contract and,
therefore, if the buyer does not pay for the goods/services, they will be in breach of contract;
they can then be taken to an appropriate court for remedy – usually an action for the price.
 If the court agrees that the customer must pay the amount due, this can be done by an
attachment of earnings order, a garnishee order, a warrant of execution or, in extreme cases, a
bankruptcy notice or liquidation.
 If an individual customer is declared bankrupt, or a corporate customer goes into liquidation or
administration, the unsecured creditors (such as trade payables) are unlikely to receive all of the
amounts due, but may receive some of the outstanding amount.
 The other legislation relevant to credit management are the Consumer Rights Act, the Late
Payment of Commercial Debts (Interest) Act and the Consumer Credit Act.
 The Data Protection Act was introduced to ensure that there were certain restrictions about the
use of data regarding individuals.
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Keywords

Acceptance: The offeree accepts the offer

Administration: A court-appointed administrator takes over the running of the company to
try and return the company to solvency

Bankruptcy: An individual cannot pay their debts

Bilateral contracts: Contracts undertaken by two persons or parties

Breach of contract: If one party does not carry out the terms of the contract, then that
party is in breach of contract

Compensatory damages: Damages that are intended to provide the claimant with the
monetary amount necessary to replace what was lost, and nothing more

Conditions: Terms that are fundamental to the contract

Consideration: Something given, promised or done in exchange for the action of the other
party

Contract: A legally binding agreement, enforceable in a court of law

Counter-offer: If an acceptance is made by an offeree which contains a new term or
condition, then this is deemed to be a counter-offer, which is a rejection of the original
offer. It constitutes a new offer which, in turn, must be accepted by the original offeror for
a contract to be made

Data controller: A person who determines the manner in which any personal data is to be
processed

Data Protection Act: Law designed to make certain restrictions about the use of data
about individuals and the use of personal data

Data subject: An individual who is the subject of personal data

Express terms: Terms that are specifically stated in the contract

Implied terms: Terms of a contract that are not specifically stated but are implied by trade
custom or law

Insolvency: A company cannot pay its debts

Invitation to treat: An invitation to another party to make an offer

Liquidation: Termination of a business operation by using its assets to discharge its
liabilities

Offer: An expression of willingness to contract on a specific set of terms, which may be
verbal or in writing

Offeree: The person to whom the offer has been made

Offeror: The person making an offer in the hope of an acceptance

Personal information: Information held about an individual

Restitutionary damages: Damages that aim to strip from a wrongdoer any gains made by
committing a wrong or breaching a contract

Retention of title clause: States that the buyer does not obtain ownership of the goods,
unless and until payment is made

Revocation of an offer: An offer is revoked if the offeror removes the offer before it is
accepted

Small Claims Track: A court process for uncomplicated lower-value claims

Statement of affairs: A statement of the bankrupt's assets and liabilities
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
Statutory demand: Final demand for payment which must be issued before a petition for
bankruptcy can be made

Terms: Items in the contract that must be carried out to avoid breach of contract occurring

Unenforceable contract: A valid contract but, if either party refuses to perform or to
complete their part of the performance of the contract, the other party cannot compel
them to do so

Unilateral contracts: Contracts undertaken by one person or group alone

Voidable contract: A contract which one party may set aside

Void contract: Not a contract at all and the parties are not bound by it

Warranties: Less important terms in the contract
Chapter summary
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Test your learning
1
What are the three main elements that must exist for a contract to be valid?
A
B
C
D
2
Offer, acceptance and consideration
Offer, acceptance and valid terms
Agreement, acceptance and consideration
Agreement, consideration and intention to create legal relations
Alan sees an advertisement in the local newspaper for a car costing £3,000. He answers
the advert, saying that he would like to buy the car. He is told by the seller that there was a
printing error and the advertisement should have read £5,000.
Can Alan insist on buying the car at £3,000? Explain the reason for your answer.
3
A business sends out a purchase quotation to a customer for goods at a cost of £15,000.
The customer replies that they would like to accept the quotation but requires that the
goods are delivered the next day.
Does the business have to provide the goods at this price of £15,000?
Explain the reasons for your answer.
4
What is a condition in a contract?
A
B
C
D
5
A fundamental term of a contract
A term expressly stated in the contract
A term not expressly stated in the contract
A term in the contract which is of lesser importance
One of the legal remedies available for a breach of contract is 'quantum meruit'.
What type of remedy is this?
A
B
C
D
6
Compensation for loss
Payment for part of the contract performed
Recovery of agreed price
Refusal to carry on with the contract
What is a garnishee order?
A
B
C
D
Amount owing paid by customer's employer
Seizure of assets
Payment by a third party
Regular payments to the court
7
Explain the purpose of including a 'retention of title' clause within a contract.
8
What are the seven principles of good practice of the Data Protection Act regarding the
handling of personal information?
9
What are the eight data subject's rights under the Data Protection Act?
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Methods of credit control
Syllabus learning outcomes/objectives
3.1
Methods for the management of debts
Learners need to understand:


3.3
The characteristics of an effective credit control system
Organisational policies and procedures specific to the management of debts
Techniques to manage liquidity
Learners need to understand:



The effect of discounts on liquidity and cash flow
The effect of changes to credit terms on liquidity and cash flow
Options available to manage cash flow: invoice discounting, factoring and credit
insurance
Learners need to be able to:



4.1
Calculate the effect of discounts on liquidity and cash flow
Calculate the annual equivalent cost using simple or compound interest
Calculate the impact on liquidity of: invoice discounting, factoring and credit
insurance
Legal and administrative procedures for debt collection
Learners need to understand:

Role of debt collection agencies and solicitors
Assessment/Chapter context
Students should be able to calculate settlement discounts and be able to explain a range of
methods that can be used to assist in both credit management and control. This can include the
use of third parties such as invoice discounting, factoring services and debt or credit insurance.
Qualification context
Students of Credit and Debt Management will meet a new formula in this chapter of the Course
Book. This is the settlement discount formula and it is used to quantify the effects of discounts.
Business context
To maintain a healthy cash flow, businesses will need to reduce any risk of incurring irrecoverable
debts along with encouraging customers to settle their accounts as early as possible. Methods that
can be used here are offering discounts and use of third-party services that can help in recovering
payment. There are costs involved in using such credit control methods and individual businesses
will need to weigh the costs and benefits before deciding on a credit control strategy for their
individual circumstances.
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Chapter overview
Benefits of
discounts
Settlement discounts
Cost of
discounts
Financial cost of less
money received
Early payment of invoice
Methods of credit control
Debt collection
agencies
Specialists in debt
collection
Factoring
services

Without
recourse

With recourse
Invoice
discounting
Selling invoices at
a discount
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Debt insurance

Premiums

Types of cover
Introduction
Settlement or cash discounts can be offered to customers to encourage early payment. However,
this can be expensive due to the loss of income.
Third-party services can also be used to assist in credit management and control. These can
include the use of debt collection agencies and finance houses which can provide credit on the
basis of amounts owed to the business by customers. These can also be expensive, in addition to
the possible loss of goodwill from customers when using such services.
1 Settlement discounts
When offering to trade with a customer on credit terms, a credit limit must be set and the terms of
payment communicated to the customer. These terms, such as net 30 days, must be clearly stated
to the customer in writing and be on all invoices, statements etc sent to the customer.
One of the terms of trading on credit that can be offered to a customer is that of a settlement
discount. A settlement or cash discount is an incentive to the customer to pay its outstanding
invoices earlier than they have to. A percentage discount off the invoice total is offered if the
customer pays within a certain period, which would be shorter than the stated, normal credit
terms.
For example, a business may offer an early settlement discount of 5%, meaning the business will
receive 95% of the invoiced amount. The cost to the business to receive the cash earlier than the
normal credit terms is 5.26% (5/95  100). This is known as the effective rate of interest.
1.1
Benefits of a settlement discount
The benefit to a business of offering a settlement discount to credit customers is that, if the
customers take up the discount, the risk of non-payment is eliminated, and the money will be
received earlier than it would otherwise have been. This means that it can be either invested to earn
interest or can be used to reduce any overdraft balance, thereby reducing the amount of interest
paid.
1.2
Costs of a settlement discount
The cost of a settlement discount is the discount deducted from the face value of the invoice. This
results in less money being received by the business although, of course, it is received sooner.
Formula to learn
It is possible to approximate the annual cost of offering a settlement discount to customers by
using the following formula:
d
365
×
× 100
100 – d N – D
Where
d = Discount percentage given
N = Normal payment term
D = Discount payment term
Assessment focus point
You must learn this formula as it is unlikely that it will be given to you in the assessment. The
formula requires repeated practice to commit to memory.
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Illustration 1
A business currently trades on 30-day terms but is considering offering a settlement discount of
2% for payment within 14 days of the invoice date.
Calculation of annual cost of settlement discount
Formula to use:
d
365
×
× 100
100 – d N – D
Enter given information into the formula:
2
365

 100
100 – 2 30 – 14
Formula becomes:
2 365

 100
98
16
(0.0204081  22.8125)  100
0.4655597  100
Annual cost of settlement discount = 46.56% (rounded to 2 decimal places)
As it would cost in excess of 46% per annum to offer this discount, it would probably be cheaper
to borrow from the bank to raise funds required, at a rate of say 5% or 6%.
Activity 1: Settlement discount cost
A business currently trades on 30-day credit terms but is considering offering a settlement
discount of 1% for payment within 10 days of the invoice date.
Required
Identify the annual percentage cost of the settlement discount.

18.4%
184.3%
1.8%
1.0%
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Activity 2: Settlement discount cost
A business currently trades on 60-day credit terms but is considering offering a settlement
discount of 2% for payment within 14 days of the invoice date.
Required
Identify the annual percentage cost of the settlement discount.

2.0%
1.62%
16.2%
162.0%
Assessment focus point
Considerations when calculating settlement discount percentages:
You may find you have a long number in your calculator when calculating the d/100-d part of
the formula. For greater accuracy, calculate the 365/N-D part first, so that you can leave the
first part of the calculation in your calculator.
Remember to multiply your answer by 100 to reach a final percentage value. This will, of course,
make a big difference to the final answer. For example, 50 as a percentage of 200 is 25% and
not 0.25.
Use a 'reasonableness test' to see if your final answer looks sensible. If your answer appears
very small or large, it may be worth double-checking your calculations.
It is more accurate to leave rounding until you have reached your final percentage figure.
1.3
Compound interest and settlement discount costs
The previous examples use a simple interest basis and this is the most normal form of the
settlement discount type of calculation. However, some businesses may choose to calculate
settlement discount costs on a compound interest basis.
The compound interest method of calculation will result in a higher percentage cost as results are
compounded over time when compared to interest calculated on a simple basis. This is because
interest is added to the principal when the compound interest method is used.
For example, £1,000 at 10% over 2 years can be calculated as follows:
Simple interest: Year 1 interest £100, Year 2 interest £100.
Compound interest: Year 1 interest £100, Year 2 interest £110 (£1,100  10%).
Although the calculations can be more complex, the use of a scientific calculator can quickly
calculate the required answer.
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Illustration 2
A business currently trades on 30-day credit terms and is considering offering a 1% settlement
discount for payment within 14 days of the invoice date.
The business uses the compound interest basis to calculate settlement discount costs and the
calculations are:
1
= 0.0101
99
365
= 22.8125
30 – 14
1 + 0.0101 = 1.0101
1.0101^22.8125 = 1.25765
1.25765 – 1 = 0.25765
0.25765  100 = 25.765%
Note. (The ^ symbol in the formula represents 'to the power of' and restates values into a
compound interest basis. This function can be found on scientific calculators on the xy key.)
Assessment focus point
When calculating a settlement discount percentage, take care to consider whether the task is
asking for the simple interest method or the compound interest method or even possibly both
methods.
1.4
Increasing credit terms
The granting of a cash discount has a positive effect on the cash flow of the business if the
discount is taken up by customers.
Increasing credit terms for a customer has the opposite effect. If an increase in credit terms for a
customer were agreed, for example, increasing its credit period from 30 days to 45 days, this
would decrease the cash flow to the business as money from this customer would be coming into
the business later. If sales revenue increases it is likely there will be a corresponding increase in
receivables along with the associated increase in any finance costs.
Illustration 3
A company is proposing to increase the credit period to customers from one month to two months.
Annual revenue is expected to increase from £1.2m to £1.8m and the bank interest cost to the
company is 5%.
Calculations for increase in finance cost:
(1)
Current value of receivables £100,000 (£1.2m/12 months)
(2)
New receivables: £300,000 (£1.8m  2/12 months)
(3)
Increase in receivables £200,000 (£300,000 – £100,000)
(4)
Additional finance cost = £10,000 (£200,000  5%) based on the average additional
receivables due to increasing the credit period to two months
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Activity 3: New receivables and annual finance cost
A business with a turnover of £2.4 million currently trades on one-month credit terms but is
considering offering customers an additional month of credit.
Required
Identify the new value of the trade receivables balance and the annual cost of financing such a
policy if the company pays interest on its overdraft at 10% per annum.
1.5
New receivables
£000
Annual finance cost
£000
A
200
20
B
200
40
C
400
20
D
400
40

Presentation of recommendations
When presenting information to management, it is important to show any findings or conclusions
clearly. When looking at finance costs, such as the settlement discount cost, it is good practice to
show the costs and benefits of implementing such a policy. For example, the benefit of the
discount will hopefully result in a better liquidity position after taking into account the cost of the
discount.
Assessment focus point
Look out for tasks on the assessment that ask for a recommendation. If you are asked for a
recommendation, then ensure you do provide one – and back up your conclusion with relevant
calculations and focus your answer on the impact on liquidity that any new policy may have.
2 Methods of debt collection
With good credit management and control procedures in place, money will normally be received
from credit customers. Sometimes encouragement such as reminder letters or telephone calls will
be needed but payment should eventually be received. However, there will be some cases in which
either the debt is never collected and has to be written off as an irrecoverable debt or where the
business has to resort to legal procedures to obtain payment.
There are specific methods that a business can use to minimise the possibility of either the loss of
the debt or resorting to legal procedures. There are a variety of different methods of collecting the
debts that are due and there are costs and benefits of each of these.
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They include:




2.1
Liaising with debt collection agencies and solicitors
Factoring
Invoice discounting
Debt insurance
Debt collection agencies and solicitors
Debt collection or credit collection agencies are commercial organisations that specialise in the
collection of debts. Most collection agencies are paid by results and charge a percentage of the
debts collected for the business, although some require an advance subscription for their services.
The collection agency will use appropriate methods for collecting the debts and these may include:



Collection by telephone and letter
Collection by personal visits
Negotiation of a payment plan with the customer
Collection agencies are an effective method of collecting debts that are proving difficult to obtain
in the normal course of trading. As collection agencies tend to be viewed as a normal business
service, they are unlikely to have an adverse impact on the relationship between the business and
its customer. However, the collection agency does, of course, charge a fee for its services.
Solicitor services can be utilised in the initial stages of the debt collection process by sending a
'solicitor letter' requesting payment. This can be a cost-effective method of collection as many
customers will settle on receipt to avoid further legal action. If the customer still refuses to pay,
solicitors will have the knowledge and experience to start the formal legal remedies that are
available.
2.2
Factoring services
Factoring is a financing service provided by specialist financial institutions, often subsidiaries of
major banks, whereby money can be advanced to a company on the basis of the security of their
trade receivables. A factor normally provides three main services and a company can take
advantage of some or all of these:



2.3
Provision of finance
Administration of the receivables ledger
Insurance against irrecoverable debts
Provision of finance by a factor
When sales on credit are made by a business, there will be a period of time elapsing before the
money for those sales is received from the business's credit customers. Many businesses may find
that they require the cash sooner than the customers are prepared to pay, for example to pay
suppliers or reduce an overdraft. This is particularly the case for fast-growing companies.
The factor advances a certain percentage of the book value of the trade receivables, often about
80%, as an immediate payment. The trade receivables are then collected by the factor and the
remaining 20%, less a fee, handed over to the business when the amounts are received by the
factor.
There is obviously a charge for this service and this will tend to be in two parts:


A service charge or commission charge
An interest charge on amounts outstanding
One further hidden cost of factoring can be a loss of customer confidence or goodwill, as
customers will be aware that the business has factored its trade receivables; this may have a
negative impact on future relations. Many customers will view the use of a factor as an indication
that a business is in financial difficulty, despite the increasing use of factoring within business.
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Illustration 4
SC Fuel and Glass are considering the use of factor finance in order to pay its own suppliers earlier
to take advantage of settlement discounts offered. The book value of the fuel division's trade
receivables is currently £700,000. The factor has agreed to advance 80% of this amount and
charges 2.5% interest on amounts advanced. The amount advanced is expected to be settled in
30 days. In addition to interest, the factor charges a fixed £1,000 administration fee.
Here SC Fuel and Glass receives £560,000 (80%  £700,000) immediately from the factor.
The factor will then collect the trade receivables on behalf of SC and will pay over the remaining
£140,000, less interest charges and administration fee, when settlement has been made by SC's
customers.
Interest charges will amount to £1,151 (£560,000  2.5%  30/365) and the £1,000 fixed
administration fee will increase total costs for SC Fuel and Glass to £2,151, leaving £137,849 to be
settled to SC Fuel and Glass by the factor.
Activity 4: Factoring cost
Hercules Haulage is experiencing liquidity problems and wishes to quickly access cash tied up in
trade receivables. Currently, trade receivables stand at £100,000 and a factor will advance 85% of
this balance immediately. The factor charges a one-off 2% commission fee on the total receivables
balance and charges 5% interest on amounts advanced. It is expected that trade receivables will
settle their accounts in 60 days.
Required
Calculate the following amounts.
£
Amount advanced by the factor
Factor's commission fee
Interest payable if receivables pay in 60 days
2.4
Administration of the receivables ledger by a factor
Many factoring arrangements go further than simply providing finance on the security of the trade
receivables; they will take over the entire administration of the receivables ledger. This will tend to
include the following:






Assessment of credit status
Sending out sales invoices
Recording sales invoices and receipts
Sending out statements
Sending out reminders
Collecting payments from credit customers
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The benefit to the business is not only a cost-saving from not having to run its own receivables
ledger but also the expertise of the factor in this area. A fee will, of course, be charged for this
service – normally based upon a percentage of revenue.
2.5
Insurance against irrecoverable debts
If a factor has total control over all aspects of credit management of the receivables ledger, then
they may be prepared to offer a without recourse factoring arrangement.
This means that the factor has no right to claim against the business if a customer does not pay.
Effectively, the factor is bearing the risk of any irrecoverable debts and, naturally, will charge a
higher fee for accepting this additional risk.
In other circumstances, the business will retain the risk of irrecoverable debts and this is known as
with recourse factoring.
2.6
Advantages and disadvantages of factoring
The benefits and costs of factoring can be summarised:
Advantages
Disadvantages
Advance of cash which may not be available
from other sources
Cost – commission and interest
Specialist debt administration skills of the factor
Potential loss of customer goodwill
Specialist debt collection skills of the factor
Higher costs for credit insurance
Saving on in-house receivables ledger costs
Problems of reverting to in-house debt
collection in future
Reduction in irrecoverable debt cost
Frees up management time
Activity 5: Services provided by a factor
Factors offer a range of services to their clients.
Required
Identify which one of the following would not be a service provided by a factor.

Insurance against irrecoverable debts
Administration of the receivables ledger
Provision of finance
Seizure of goods from customers who do not pay
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Activity 6: A disadvantage of using a factor
There can be a number of disadvantages in using a factor.
Required
Identify which one of the following would be considered a disadvantage of using a factor.

Cost savings
Reaction of some customers
Advance of cash
Reduction in irrecoverable debts
2.7
Invoice discounting
One of the costs of factoring is the potential loss of customer goodwill if it is known that the
business is using a factor to collect its debts. The reason for this is that some customers may infer
cash flow problems from the use of a factor, which may not give them confidence to continue
trading with the business.
An alternative, therefore, is invoice discounting which is a service related to factoring. Invoice
discounting is where the debts of a business are purchased by the provider of the service at a
discount to their face value. The discounter simply provides cash up front to the business at the
discounted amount, rather than have any involvement in the business's receivables ledger. Under a
confidential invoice discounting agreement, the business is still responsible for collecting its own
debts and the business's customers will only be aware of the arrangement if they do not pay their
debt. As a result, invoice discounting is often chosen by businesses that wishes to retain control of
their own receivables ledger.
The cost to the business is the discount at which the trade receivables are purchased. Invoice
discounting can be used for a portion of the trade receivables only and is therefore often used for
a short-term or one-off exceptional cash requirement.
Assessment focus point
Although the names are similar, be sure not to confuse settlement discounts and invoice
discounting. These are two different methods of credit management. As a reminder, a
settlement discount is where a customer takes advantage of a reduction in an invoice value for
early payment; invoice discounting is where invoices are sold to a third party for less than their
face value.
Illustration 5
HGT Ltd recently entered into a confidential invoice discounting agreement. Under the agreement,
the invoice discounter purchased 65% of HGT Ltd's receivables balance at a 10% discount.
HGT Ltd's receivables balance was £150,000 and therefore the discounter purchased £97,500 of
receivables for £87,750.
£150,000  65% = £97,500
£97,500  90% (100% - 10%) = £87,750
HGT Ltd therefore received a cash advance of £87,750 and its customers will be unaware of the
arrangement unless their account is one of the accounts purchased by the discounter and they fail
to repay what they owe. In this instance, the debt will be chased by, and be payable to, the invoice
discounter.
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Activity 7: Invoice discounting and factoring
Two methods of credit management and control are the use of invoice discounting and factoring.
Required
Distinguish between invoice discounting and factoring arrangements.
2.8
Debt insurance and credit insurance
Debt insurance and credit insurance is insurance cover taken out against the incurring of
irrecoverable debts. It has nothing to do with advances of money or collection of trade receivables
(as with factoring) but is simply an insurance policy to cover debts which become irrecoverable
and are never settled by the customer.
Such insurance, also known as credit insurance, is available from a number of sources and there
are several types of policy available.
2.9
Types of insurance policy
The most common policy is a whole turnover policy. This type of policy can operate in one of two
ways:
(a)
The entire receivables ledger can be covered, but the amount paid out for any irrecoverable
debt claim would only be normally about 80% of the claim.
(b)
Alternatively, approximately 80% of the trade receivables can be insured for their entire
amount and any claim on these trade receivables would be paid in full.
Either way under this type of policy, only a proportion of irrecoverable debts will be covered for
loss.
A further type of policy is an annual aggregate excess policy where irrecoverable debts are
insured in total above an agreed limit or excess, in a similar way to household or car insurance
policies.
It is possible to purchase insurance for a specific receivable account rather than receivables in
total so that an individual customer is identified by name on the policy.
Key account policies will name a selection of key customers on a policy taken out. Typically, the
accounts identified on the policy will represent a substantial part of the total turnover.
Catastrophe insurance, sometimes referred to as 'supercat', is a specialist field of insurance where
a company can take out insurance against non-payment by customers due to severe
circumstances, for example, natural disasters. The cost of insurance will differ, depending upon the
insurer and the type of policy, but premiums tend to be 1–2% of the amounts insured.
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Illustration 6
SC Fuel and Glass had a whole turnover policy covering 80% of irrecoverable debts. A customer
has been declared bankrupt, owing SC Fuel £120,000 including VAT.
Assuming the VAT element of £20,000 (120,000/1.2  0.2) can be claimed back from HMRC, the
remaining net amount of £100,000 will then be claimed under the insurance policy. SC Fuel will
receive 80% (£80,000) from the insurance company and the balance of £20,000 will be written off
as an irrecoverable debt.
Activity 8: Debt insurance claim
A company pays a premium for a whole turnover debt insurance covering 75% of any irrecoverable
debts. One customer owes £19,800 including VAT at 20% and the company intends to claim the
VAT back from HMRC. The company will claim the maximum allowed under their debt insurance
policy.
Required
Calculate how much the company can claim under debt insurance.
Activity 9: Type of insurance policy
A business has insured its total irrecoverable debts above an agreed limit of £2,500.
Required
Identify the type of insurance policy this is.

Partial turnover policy
Whole turnover policy
Specific receivables' policy
Annual aggregate excess policy
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Chapter summary
 In agreeing credit terms with a customer, it may be that the customer is offered a settlement
discount for payment earlier than the agreed credit period – although this has a benefit to the
seller in that the cash is received sooner, it also has a cost in that less is received due to the
discount.
 If amounts due from credit customers cannot be recovered in the normal course of business, there
are a variety of other alternatives.
 A debt collection agency will use appropriate methods for collecting trade receivables on a
business's behalf without normally affecting customer goodwill – a fee will be charged for the
agency's services.
 A factoring agreement can be for the provision of finance, the administration of the receivables
ledger and may include a 'without recourse' agreement for protection against irrecoverable debts.
 The fees charged by a factor will depend upon the level of service provided, but it can also affect
customer goodwill.
 Benefits of factoring include an advance of cash, specialist services of the factor and a reduction
in the receivables ledger as well as management time and costs.
 Invoice discounting is similar to factoring although, as it is anonymous, it will not tend to affect
customer goodwill and can be used for a portion of trade receivables.
 Debt insurance is not a method of collecting trade receivables but of insuring against the risk of
irrecoverable debts.
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Keywords

Annual aggregate excess policy: Irrecoverable debts are insured for an amount above an
agreed limit or excess

Annual cost of offering settlement discount (simple interest method):
d
365

 100%
100 – d N– D

Debt and credit collection agencies: Commercial organisations that specialise in the
collection of trade receivables

Debt insurance and credit insurance: Insurance cover for irrecoverable debts, either for the
majority of the receivables ledger or for specific receivables ledger accounts

Factoring: A service whereby a factor advances money on the security of a business's trade
receivables and may also provide other services, such as administration of the receivables
ledger

Invoice discounting: A service whereby sales invoices are purchased for cash immediately at
a discount to their face value

Settlement or cash discount: Discount offered to customers for payment of the due amount
earlier than the normal credit terms

Whole turnover policy: Insurance for the whole receivables ledger for, say, 80% of
irrecoverable debts; or for 80% of the receivables ledger for all irrecoverable debts

With recourse factoring: A factoring arrangement where the business retains the risk of
irrecoverable debts

Without recourse factoring: A factoring arrangement where the factor bears all the risk of
irrecoverable debts
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Test your learning
1
Your company currently has an average credit period of 45 days but is considering offering
a 2% settlement discount for payment within 10 days.
Using the simple method, what is the approximate annual cost of this discount?
A
B
C
D
2
2.0%
2.13%
21.3%
213.0%
Factoring arrangements may be either without recourse factoring or with recourse factoring.
Viewed from the perspective of the company, which of the following correctly describes
one of these methods?
A
B
C
D
3
Without recourse factoring does not cover irrecoverable debts.
With recourse factoring does cover irrecoverable debts.
Without recourse factoring does cover irrecoverable debts.
With recourse factoring does not cover irrecoverable debts.
Which of the following is not a cost of using a factoring service for receivables ledger
administration and collection of debts?
A
B
C
D
Advance of cash
Commission charges
Loss of goodwill
Reverting back to in-house receivables ledger administration
4
Explain two types of debt insurance policy that a business could take out.
5
A company has a receivable outstanding amounting to £2,400 including VAT at 20%. The
company is able to claim 90% of unpaid debts under their debt insurance policy. Assume the
VAT element can be reclaimed from HMRC.
Calculate the amount that can be claimed under the policy and any amount to be written
off as irrecoverable.
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Managing the
supply of credit
Syllabus learning outcomes/objectives
3.1
Methods for the management of debts
Learners need to understand:

The characteristics of an effective credit control system

Organisational policies and procedures specific to the management of debts
3.2
Manage accounts receivables
Learners need to be able to:

Prepare an aged receivables analysis report

Apply the 80/20 rule to receivables balances

Analyse ledger balances and take corrective action

Calculate irrecoverable and doubtful receivables: write-offs and provisions, the
impact on cash flow and VAT implications
3.4
Communicate with stakeholders using a professional and ethical approach
Learners need to understand:

Organisational policies when communicating with stakeholders
Learners need to be able to:

Communicate objectively to relevant stakeholders
4.1
Legal and administrative procedures for debt collection
Learners need to understand:

The internal procedures used in the debt collection process
Assessment context
Credit and Debt Management students must be able to interpret an aged receivables analysis
and apply a credit control policy to identify any issues and decide upon appropriate actions.
Students must also be able to identify irrecoverable debts and make allowances for doubtful
debts, suggesting action points on how they can be dealt with.
Qualification context
Bookkeeping for irrecoverable and doubtful debt allowances are covered at Level 3 in the
Financial Accounting: Preparing Financial Statements unit.
Business context
Effective cash management will include the use of a debt collection policy to guide on actions to
take when issues are identified from the aged receivables report or from other available credit
information. Actions to take can include reminder telephone calls through to more serious
processes, such as legal action.
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Chapter overview
Irrecoverable and
doubtful debts
Set limits

Review limits
Old debts

No current trading

Credit limit exceeded

No response from customer
Aged receivables
analysis
Credit limits


Managing the supply
of credit
Debt collection policy
Debt collection process

Invoices

Statements

Reminder letters

Telephone calls

Stop list
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Slow payers
Introduction
The supply of credit to customers is managed by the business's debt collection policy, along with
the use of aged receivables reports.
The debt collection policy will outline the appropriate action that should be taken, if any, to
encourage payment and the collection of outstanding debts.
Actions will need to be decided on for each individual customer and that customer's own
circumstances. For example, would a reminder telephone call be sufficient or should stronger
actions be taken – such as sending legal letters or using debt collection agencies?
The aged receivables report will also help identify potential irrecoverable or doubtful debts.
Decisions will need to be taken on whether a particular debt should be written off as irrecoverable
or to provide an allowance for the amount outstanding.
1 Transactions with credit customers
Once it has been agreed with a customer that they may trade on credit terms with the business,
an account will be set up for that customer in the receivables ledger. The entries in this account
will be invoices and credit notes sent to the customer and receipts from the customer.
One of the roles of the credit control team will be to monitor, on a regular basis, the transactions
on each receivable's account and, in particular, the balance on the account.
1.1
Placing an order
The first step in the monitoring of a credit customer's activities is at the initial stage of each
transaction when the customer places an order for more goods. When the initial agreement was
made with the customer to trade on credit terms, a credit limit will have been set by the credit
controller for that customer.
The credit limit is the maximum amount that should be outstanding on the customer's account in
the receivables ledger at any point in time.
When a customer places an order, the first step is to check that the value of the order does not
take the customer's account over their credit limit. If the value of the order means that the
customer's balance exceeds the credit limit, then this must be discussed with the customer.
Illustration 1
One of SC Fuel and Glass's customers is Nerrington Engineering. On 14 July 20X8, the balance on
its account in the receivables ledger is £4,484.04, which is made up as shown in the table below:
£
26/04/X8
Invoice 203741
1,350.67
28/05/X8
Invoice 203882
994.60
06/06/X8
Credit note 016452
(103.25)
14/06/X8
Invoice 203903
1,226.57
28/06/X8
Invoice 203911
1,015.45
4,484.04
On this date, Nerrington placed an order for an additional £1,245.60 of fuel.
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This will take its account balance over its credit limit of £5,000. The credit controller for the fuel
division may decide to make a telephone call to the accountant at Nerrington to explain the
situation. From here, it may be agreed that Nerrington will arrange payment for £2,242.02 which
will pay off invoices 203741 and 203882, less the credit note 016452. Once this has been received,
it would then be agreed that the new order will be processed and the fuel delivered.
Activity 1: Credit limits
Before trading commences with a credit customer, a credit limit will be agreed between the
business and the customer and it is important that this limit should not be exceeded.
Required
Identify the effect if a customer exceeds the agreed credit limit.

Increasing goodwill with the customer
Ensuring the cancellation of any settlement discount offered
Loss of sale
Increasing the risk of non-payment of the amount due
1.2
Review of customer accounts
As well as checking that each order does not mean that the customer's balance exceeds their
credit limit, each customer's account should be monitored on a regular basis. This review should
involve looking for debts that are not being paid within the stated credit terms and old debts that
have not been paid at all.
In order for this review of customer accounts to be meaningful, it is important that the customer
accounts are kept up to date and accurate so that the correct balance and position can be seen
at any point in time.
2 Aged receivables analysis
One particularly useful method of reviewing customer account balances is by producing an aged
receivables analysis.
An aged receivables analysis is a method of internal communication that splits the total balance
on a customer's account into amounts which have been outstanding for particular periods of
time, for example:




Current – up to 30 days
31 to 60 days
61 to 90 days
Over 90 days
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Illustration 2
We will return to the account of Nerrington Engineering in the receivables ledger of SC Fuel and
Glass. At 30 June 20X8, the account balance is made up as follows:
£
26/04/X8
Invoice 203741
1,350.67
28/05/X8
Invoice 203882
994.60
06/06/X8
Credit note 016452
(103.25)
14/06/X8
Invoice 203903
1,226.57
28/06/X8
Invoice 203911
1,015.45
4,484.04
The precise age of each of the outstanding invoices can be shown more clearly if an aged
receivables analysis is prepared.
Aged receivables analysis – 30 June 20X8
Nerrington
Total
£
Credit
limit
£
Current <30
days
£
31–60
days
£
61–90
days
£
>90
days
£
4,484.04
5,000
2,138.77
994.60
1,350.67
–
Engineering
Note that the 'current' portion is made up of Invoices 203903 and 203911, less the credit note
016452, which were all issued in June.
Activity 2: Preparation of an aged receivables analysis
You are working in the credit control department of Bourne Ltd. An extract from the company's
aged receivables analysis at 30 September 20X4, together with information on the transactions
that took place during October, is shown below.
Bourne Ltd
Aged receivables analysis – 30 September 20X4. Credit terms: 30 days.
Customer
name and
ref
Total
amount
Current
(<1 month)
£14,000
£5,000 B96
Longparish
£7,000
£7,000 B95
Stockbridge
£6,000
Overton
Andover
£15,000
Greatley
£5,500
TOTAL
£47,500
O/s
1–2 months
O/s
2–3
months
O/s
>3 months
£9,000 B49
£3,000 B23
£11,000 B72
£3,000 B11
£4,000 B42
£5,500 B34
£12,000
£11,000
£16,000
£8,500
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Customer
Information for October 20X4
Overton
Paid invoice B49 £9,000.
Invoice B96 remains unpaid.
Invoice B101 £5,000 issued.
Longparish
Paid invoice B95 £7,000.
Invoice B111 £6,600 issued.
Stockbridge
Paid invoice B11 £3,000.
Invoice B23 remains unpaid.
Invoice B102 £2,775 issued.
Andover
Paid invoice B42 £4,000.
Invoice B72 £11,000 remains unpaid.
Greatley
Paid half invoice B34, balance remains unpaid.
Required
Prepare an aged receivables analysis as at 31 October 20X4.
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2.1
Using the aged receivables analysis
The regular review of the aged receivables analysis should highlight the following potential
problems:




2.2
Credit limit exceeded
Slow payers
Recent debts cleared but older outstanding amounts
Old amounts outstanding but no current trading
Credit limit exceeded
As we have already seen, when an order is placed by a credit customer, the first step is to check
whether the customer's credit limit will be exceeded as a result. However, this check may not
always take place or, if the order is placed when the customer's account is not up to date, it may
appear as if the credit limit will not be exceeded and therefore the sale is agreed.
If review of the aged receivables analysis indicates that a customer's credit limit has been
exceeded, then this must be investigated.
If a customer is highlighted in the aged receivables analysis as having exceeded their credit limit
then, normally, the customer will be told that no further sales will be made to them until at least
some of the outstanding balances have been paid. In some circumstances, liaison between the
receivables ledger and the sales department may result in an increase in the customer's credit
limit.
Activity 3: Recording invoices correctly
An invoice to a customer was not promptly recorded in the customer's receivables ledger account.
Required
Identify what effect there might be on the customer's account.

The balance may be too high
The customer's credit limit may be exceeded
Settlement discounts may be lost
Further sales to the customer may be stopped
2.3
Slow payers
Some businesses can be identified from the aged receivables listing as being slow payers: they
always have amounts outstanding for, say, 31–60 days and 61–90 days, as well as current
amounts.
In these cases, consideration should be given to methods of encouraging the customer to pay
earlier. This could be in the form of a reminder letter or telephone call or perhaps the offer of a
settlement discount for earlier payment.
2.4
Recent debts cleared but older amount outstanding
If a customer is generally a regular payer and fairly recent debts have been cleared, but there is
still an outstanding older amount, then this will normally indicate either a query over the amount
outstanding or a problem with the recording of invoices, credit notes or payments received.
If there appears to be no communication from the customer about a queried invoice that would
account for the old outstanding debt, then the invoice postings, credit note postings and
payments received from that customer should be checked to ensure that there have been no
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errors which have resulted in the recording of this outstanding amount. If there appear to be no
errors, then the customer should be contacted in order to find out what the problem is concerning
payment of this particular amount.
2.5
Old amounts outstanding and no current trading
This situation would be of some concern for the credit control team. It would appear that the
customer is no longer buying from the business but still owes money from previous purchases. In
this case, the customer should be contacted immediately and payment sought. If no contact can
be made with the customer, or there is a genuine problem with payment (such as bankruptcy or
liquidation) consideration should be given to writing off the debt as irrecoverable.
Illustration 3
Given below is an extract from the aged receivables analysis of the fuel division of SC Fuel and
Glass at 30 June 20X8.
Aged receivables analysis – 30 June 20X8
Current
<30
days
£
Total
£
Credit
limit
£
Pentagon Ltd
7,357.68
10,000
4,268.79
White & Co
1,363.56
2,000
1,135.46
Nantwich Ltd
3,745.24
5,000
732.34
Bella Partners
4,836.47
4,000
2,295.36
Manfred Paul
832.56
1,000
31–60
days
£
61–90
days
£
>90
days
£
3,088.89
228.10
1,983.36
1,029.54
2,541.11
832.56
The position of each customer must be considered and any necessary action taken.
Pentagon Ltd
When the credit agreement with Pentagon Ltd is checked, it is noted that this
long-standing customer is allowed 60 days of credit from the invoice date,
therefore there are no amounts overdue.
White & Co
The credit terms for this business are 30 days from the invoice date, therefore the
amount over 60 days of £228.10 is certainly overdue. However, with no other
overdue amounts, this might indicate that there is a query regarding this figure;
the customer's correspondence file should be checked. If there appears to be no
queried amount, then there might have been an error in the posting to the
account, which must also be checked.
Nantwich Ltd
The credit terms for this business are 30 days from the invoice date, therefore the
vast majority of the debt is outstanding. This company appears to be a slow
payer and consideration should be given to encouraging them to pay within the
stated credit period.
Bella Partners Credit terms of 30 days, therefore over half the debt is overdue. The customer
has also exceeded their credit limit and the reason for this should be investigated.
It may be decided to stop any further supplies to the customer until the overdue
amounts are paid.
Manfred Paul
This is of great concern, as there has been no current trading but there is an old
amount outstanding. The customer should be contacted immediately with a view
to collection of the amount due.
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2.6
The 80/20 rule
The 80/20 rule is that, in general, 80% of the value of amounts owed by customers will be
represented by 20% of the customer accounts.
According to the 80/20 rule, if the largest accounts (making up 20% of customers) are reviewed
frequently, this should mean that approximately 80% of the total of receivables balances are
regularly reviewed.
The remaining smaller balances, making up only 20% of the receivables total, can then be
reviewed on a less-frequent basis.
2.7
Materiality
Another approach when analysing receivables is to prioritise the receivables ledger by taking into
account the materiality or significance of the debt. Thus overdue debts below a certain amount
should be ignored until larger, more significant debts have been pursued as a priority.
This allows specific areas to be targeted by the credit control function of a business to minimise
losses due to irrecoverable debts or to improve cash flow. It also takes into account that some
debts may not be worth pursuing as the time and costs involved may outweigh the likely benefits.
Assessment focus point
When considering whether an item is material, always put this into context with additional
information supplied. A customer failing to pay a £1,000 invoice may be material to a small
business but, perhaps, not material to a large multinational corporation.
2.8
Measuring the average period of credit
It can be useful for a business to be able to determine the average period of credit taken by its
customers in total. If these figures are compared over time, then any improvement or
deterioration of credit control procedures can be identified.
The most common method of measuring the average period of credit is using the accounts
receivable collection period. This can be compared over time and also can be compared with the
accounts payable payment period. If the accounts receivable collection period is consistently
shorter than the accounts payable payment period, then this will aid liquidity.
2.9
Increase in credit limit
There will be occasions when a customer specifically requests an increase in credit limit. It may be
that the customer wishes to place an order that will exceed the credit limit. The aged receivables
listing can be a useful tool in making a decision about any increase in credit limit, as it allows the
credit controller to see the trading history of the customer, whether or not they have kept within
their current limit in the past and paid according to their credit terms.
Activity 4: Action to take
The aged receivables analysis for a business shows that a customer has £736.50 owing from the
current period and £104.00 due from the 61/90-day period.
Required
Explain the course of action that should be taken concerning this customer.
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3 Irrecoverable debts
The aged receivables analysis can also be used to identify debts which might be irrecoverable.
These consist of irrecoverable debts and doubtful debts. Any debts that are not paid will, of
course, have a negative impact on the cash flow of the organisation, as working capital will be
reduced by the comparative amount of balances unpaid.
An irrecoverable debt is one where it is almost certain that the monies will not be received. A
doubtful debt is one where there is some doubt over the eventual receipt of the money, but it is
not such a clear case as an irrecoverable debt. The reason for the distinction between the two is
that in the financial accounting records, an irrecoverable debt is written off, and no longer
appears in the ledger or on the statement of financial position, whereas a doubtful debt has an
allowance or a provision made against it – so it still appears in the ledger, and on the statement
of financial position where it is netted off against the receivables balance.
3.1
Identification of irrecoverable and doubtful debts
The following can be clues indicating a potential irrecoverable debt:








Evidence of long-outstanding debts from the aged receivables analysis
A one-off outstanding debt when more recent debts have been cleared
Correspondence with customers
Outstanding older debts and no current business with the customer
A sudden or unexpected change in payment patterns
Request for an extension of credit terms
Press comment
Information from the sales team
Illustration 4
Given again is the extract from the fuel division's aged receivables analysis at
30 June 20X8.
Aged receivables analysis – 30 June 20X8
Total
£
Credit
limit
£
Current <30
days
£
31–60
days
£
Pentagon
Ltd
7,357.68
10,000
4,268.79
3,088.89
White & Co
1,363.56
2,000
1,135.46
Nantwich
Ltd
3,745.24
5,000
732.34
Bella
Partners
4,836.47
4,000
2,295.36
Manfred
Paul
832.56
1,000
>90
days
£
228.10
1,983.36
1,029.54
2,541.11
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832.56
The two debts that may be under consideration are the old debts owing by
White & Co and by Manfred Paul.
Upon investigation, it is discovered that the amount of £228.10 is in dispute with White & Co as
they have no record of having received this delivery of fuel. SC's despatch team are still trying to
find evidence that the fuel was supplied but, as yet, they can find no delivery note to support the
invoice that was sent out. This could be viewed as a doubtful debt as there is certainly some
doubt as to whether this was, in fact, a valid sale or not.
Manfred Paul is an individual customer with whom SC has traded periodically. Upon contacting
Manfred Paul, it has been discovered that he has been declared bankrupt and has no funds to
pay his suppliers. This debt will probably be declared an irrecoverable debt.
3.2
Write-offs and provisions
If a member of the credit control team discovers that a debt is highly likely to be classified as
irrecoverable or doubtful, then it will probably not be that person's responsibility to write the debt
off or set up a provision or allowance against it. This is normally the role of a more senior member
of the accounting function, as this will impact on the preparation of the financial statements of a
business.
To write an irrecoverable debt off, ultimately the debt will be deleted from the customer's
receivable account (a credit entry in the accounts) and an irrecoverable debts expense on the
statement of profit or loss will be debited with the same amount. Additional treatment may be
required if the irrecoverable debt includes VAT (see below).
To create a provision for a doubtful debt, a provision (or allowance) for doubtful debts account
on the statement of financial position should be credited with the amount of the doubtful debt
and a provision (or allowance) for doubtful debt account on the statement of profit or loss should
be debited with the same amount. Additional treatment for VAT is not necessary because the debt
is not being written off.
Activity 5: Irrecoverable and doubtful debts
When a customer's account is overdue, the amount involved may become an irrecoverable or a
doubtful debt.
Required
Which of the following is correct about irrecoverable and doubtful debts?

An irrecoverable debt will not be received and an allowance is made
A doubtful debt may be received but it is written off
An irrecoverable debt may be received and an allowance is made
A doubtful debt may not be received and an allowance is made
Activity 6: Irrecoverable, doubtful debts and no action
At the year ending 31 December 20X5, total receivables amount to £17,221.75.
This amount is owed between three customers and is analysed in the aged receivables analysis as
below.
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Aged receivables analysis – 31 December 20X5
Total
£
Credit
limit
£
D. Layed Ltd
1,600.29
2,000
Timley plc
4,820.90
5,000
Busted Ltd
10,800.56
10,000
Current
<30
days
£
31–60
days
£
61–90
days
£
>90
days
£
1,600.29
4,820.90
2,644.15
8,156.41
Required
Identify in your opinion which accounts should be written off, have an allowance provided for or
where no action is required.
No action
Allowance for
doubtful debt
Write off as
irrecoverable
D. Layed Ltd
Timley plc
Busted Ltd
Assessment focus point
Writing off a customer's account will impact on the financial statements but this should not
prevent further chasing; if the debt is received at a later date, the amount can easily be
written back into the books of account of the business.
3.3
VAT implications
When a debt is written off as irrecoverable, the VAT element of the debt will be included with the
amount outstanding from the customer. Cash flow issues arise as the business may have
accounted for the VAT element to HM Revenue & Customs (HMRC).
3.4
VAT bad debt relief
When the business has accounted for the VAT to HMRC, then bad debt relief can be used to claim
back or net-off VAT suffered by the business.
VAT bad debt relief can be claimed when:



The VAT has been accounted for to HMRC
The debt has actually been written off as irrecoverable in the books of account
The debt is over six months old
Illustration 5
A customer has gone bankrupt owing AB Ltd an invoice for £4,500 that includes VAT at 20%. The
debt is over six months old and AB Ltd has previously passed on the VAT element of the invoice to
HMRC. The total debt has been written off as irrecoverable in AB Ltd's books.
How much can be claimed under bad debt relief and how much should be written off as
irrecoverable?
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The VAT element of the invoice is £750 (4,500/1.2  0.20) and this can be claimed back from
HMRC. The amount that should be written off as irrecoverable is £3,750 (4,500 – 750) as this is
the net amount of the invoice. As £4,500 has already been written off in AB Ltd's books, £750
needs to be written back so that the correct amount is accounted for.
3.5
Professional ethics and irrecoverable and doubtful debts
Writing off debts as irrecoverable will have an effect on reported profits and issues can arise
when debts are written off in one period and then subsequently written back in another period in
an attempt to smooth profits between accounting periods.
Accounting for debts should reflect the financial reality of the situation and be dealt with
adhering to the fundamental ethical principles of integrity and objectivity. This means that
accounting should be completed with honesty and without any conflict of interest when reporting
results of a business.
4 Debt collection policy
Most businesses will have some sort of policy, whether formal or informal, regarding the collection
of debts and the processes that will take place to chase up any outstanding amounts.
4.1
Debt collection process
The debt collection process starts with the sending out of the sales invoice on which the credit
terms should be clearly stated. Thereafter, a variety of external communications would be sent to
the customer to encourage them to pay within the credit terms and, for those overdue debts, a
further series of reminders.
A typical debt collection process can be illustrated:
Invoice sent
Statement sent
Telephone reminder
Reminder letters
Stop list
External means of
debt collection
4.2
Sales invoice
Once a sale has been made, a sales invoice can be sent to the customer. This should be promptly
sent, as soon as the goods or services have been provided, and should clearly state the payment
period agreed.
4.3
Statements
Most businesses will then send a monthly statement to the customer, showing the balance at the
end of that month and how that is made up, including invoices, credit notes and payments
received.
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4.4
Telephone calls
An overdue debt is one which has not been paid within the stated credit period. Once a debt has
become overdue, it is common practice to telephone the customer to enquire about the situation,
determine whether or not there is a query over the amount due and agree when the debt will be
paid.
When making this type of telephone call, particular attention should be given to the following
matters:

Discussion with the customer should always be courteous.

The precise amount of the debt should be pointed out, and the fact that it is overdue.

It should be established whether there is any query with regard to the debt and, if so, any
appropriate action agreed to resolve the query.

If there is no query, then a date for payment of the debt should be established.
It is important to keep precise notes of what has been agreed in a telephone conversation with a
customer, as this may need to be confirmed by letter. For example, if a customer agrees over the
telephone to clear an outstanding amount by paying in four instalments, then this should be
confirmed to the customer in writing.
4.5
Reminder letters
If there has been no response to telephone calls requesting payment of the overdue amount, then
this is followed up with a reminder letter.
This first reminder letter is designed to point out the facts – the amount outstanding – and as a
reminder or encouragement to pay the amount due. As with all letters to customers, it must be
courteous and succinct as well as firm.
The reminder letter will be sent out when the debts are a certain amount of time overdue. The
timescale of the reminder letter will depend upon the organisation's policy towards debt collection
but usually it is sent out seven days after a debt becomes overdue. Accordingly, if an invoice is
sent to a customer with 30-day credit terms, then the first reminder letter will be sent out 37 days
after the invoice.
An example of a typical first reminder letter is given below:
Date
Dear Sir
Account No: 385635/A
I do not appear to have received payment of the invoices detailed below. I trust that this is an
oversight and that you will arrange for immediate payment to be made. If you are withholding
payment for any reason, please contact me urgently and I will be pleased to assist you.
Invoice No
Terms
Due date
Amount
£
If you have already made payment, please advise me and accept my apology for having
troubled you.
Yours faithfully
Credit controller
4.6
Final reminder letters
If there is no response from the initial reminder letter, then there will be little point in sending a
second reminder letter. However, at this stage a telephone call might be useful to clear up any
misunderstanding and to assess whether further action is required.
The options for the business at this point are generally:

To put the debt into the hands of a debt collection agency
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
To take the customer to court for payment

To suspend any further sales to the customer by placing the customer on a stop list until
payment is received
An example of a typical stop list letter is given below:
Date
Dear Sir
Account No: 385635/A
Further to our invoices detailed below, and our previous correspondence, I do not appear to have
received payment. I trust that this is an oversight and that you will arrange for immediate
payment to be made. If you are withholding payment for any reason, please contact me urgently
and I will be pleased to assist you.
Invoice No
Terms
Due date
Amount
£
I regret that unless payment is received within the next seven days, I will have no alternative but
to stop any further sales on credit to you until the amount owing is cleared in full. If you have
already made payment, please advise me and accept my apology for having troubled you.
Please note that if we are forced to take legal action, you may become liable for the costs of such
action which, if successful, may affect your future credit rating.
Yours faithfully
Credit controller
4.7
Management briefing notes
In addition to drafting letters to customers, the credit control function may be requested to
prepare briefing notes for senior management, outlining any potential problems and the
consequences (eg an irrecoverable debt) along with any actions taken. The key for briefing notes
is to keep the communication short and to contain the relevant information surrounding any
credit control issues identified.
Assessment focus point
Look out for instructions on how you should present your written answers. For example, are
briefing notes required for management or is a letter to be prepared for a customer? The type
of communication will determine the style of communication expected.
If a letter format is required, ensure you include appropriate salutations and it is written in a
formal business manner, avoiding slang and texting language abbreviations – keep your
communications professional!
Illustration 6
The glass division of SC Fuel and Glass has the following written policy for debt collection.
Debt collection policy
(1)
Invoices should be sent out on the same day as goods are delivered.
(2)
An aged analysis of receivables should be produced monthly.
(3)
Statements are sent to credit customers on the first working day of each month.
(4)
A reminder letter is sent when a debt is seven days overdue.
(5)
A telephone call to chase payment must be made when a debt is 14 days overdue.
(6)
When the debt is 30 days overdue, the customer will be placed on the stop list and a letter
sent confirming this. A meeting should then be arranged with the customer in order to
discuss the account position.
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(7)
When the debt is 60 days overdue, it will be placed in the hands of a debt collection
agency or legal proceedings will be commenced, based upon the decision of the financial
controller.
An invoice was sent to Yarrow Ltd, for £8,570 on 1 June on 30-day credit terms. This debt is still
outstanding at 30 June.
The process that would follow, assuming that the money was not received, would be:

7 July – first reminder letter sent

14 July – telephone reminder

30 July – placed on stop list and final reminder letter sent. Meeting arranged to resolve the
payment problem

29 August – decision taken regarding final treatment of overdue amount
Activity 7: Telephone calls to customers
One method of reminding customers to settle their accounts is the use of telephone calls.
Required
Explain the factors that are important when planning a telephone call to a customer regarding
an overdue account.
Assessment focus point
Sometimes adhering to a credit or debt collection policy too closely can cause problems. For
example, if a well-established customer is late in paying their account, it would be good
practice to check first with the chief credit controller before putting the account on stop. This
can help to avoid any unnecessary bad feeling with the customer and potential loss of
custom.
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5 Example of a credit control policy and procedure
The following is an example of a typical credit control policy and procedure.
5.1
5.2
5.3
5.4
New accounts
(1)
One bank reference and two trade references are required.
(2)
A credit reference agency report and the last three years' published accounts for limited
companies need to be analysed.
(3)
A credit reference agency report and the last three years' accounts for a sole trader need
to be analysed.
Existing customers
(4)
A credit reference agency report to be obtained on an annual basis, together with the
latest annual accounts from Companies House or directly from the customer.
(5)
A trading history review to be undertaken annually to review the performance against
credit limits and terms of payment.
(6)
Annual review of usage of the customers' credit limit and to ensure that an outdated credit
limit is not in existence.
Credit terms
(7)
Standard terms are 30 days from invoice. Any extension to be authorised by the finance
director.
(8)
A 2% settlement discount to be offered to all accounts with a profit margin of 50% or
greater.
Debt collection process
(9)
Invoices to be despatched on day of issue.
(10)
Statements to be despatched in the second week of the month.
(11)
Aged receivables analysis to be produced and reviewed on a weekly basis.
(12)
Reminder letter to be sent once an account is overdue.
(13)
Telephone chaser for accounts 15 days overdue.
(14)
Customer on stop list if no payment is received within five days of the telephone chaser.
(15)
Letter threatening legal action if payment not received within 30 days of the first letter.
(16)
Legal proceedings or debt collection agency instructed, subject to approval of the finance
director.
(17)
Prepare a report suggesting an appropriate allowance for doubtful debts.
(18)
If, at any stage in the process, the customer is declared insolvent or bankrupt, then contact
the insolvency practitioner in order to register the debt and notify the financial accountant
so that the VAT can be reclaimed.
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5.5
Credit control policy
(1)
Invoices must be issued on the same day as goods despatched.
(2)
An aged analysis of trade receivables is to be produced monthly.
(3)
Credit terms are strictly 30 days from the date of invoice.
(4)
Statements are despatched on the first working day of each month.
(5)
A reminder letter must be sent when debt is 14 days overdue.
(6)
A telephone call to chase payment must be made when a debt is 21 days overdue.
(7)
The customer is placed on the stop list when debt is 30 days overdue and a meeting
arranged.
(8)
A letter threatening legal action will be sent when the debt is 45 days overdue.
(9)
Legal proceedings are to be commenced when a debt is 60 days overdue, subject to the
agreement of the financial controller.
Activity 8: Aged receivables action plan
The credit control policy of Kencorp Ltd and an extract from the company's aged receivables
analysis are given below.
Aged receivables analysis – 30 June 20X6
Current
<30
days
£
Total
£
Credit
limit
£
10,800
12,000
DD DIY Ltd
6,800
10,000
5,200
1,200
AP Partners
3,250
4,000
1,000
1,000
1,250
Gatfield Ltd
17,640
25,000
8,200
8,600
840
Krane Ltd
21,200
20,000
8,900
12,300
Crane Co
3,200
4,000
3,200
Castle Builders
31–60
days
£
61–90
days
£
>90
days
£
10,800
400
Required
Suggest an action for each of Kencorp Ltd's customers and include any recommendations for
an allowance for doubtful debts.
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Assessment focus point
When preparing written action, points to be taken for late payers always consider all the
information available and how this can influence the appropriate action to take.
Factors for you to consider can include:

Would a telephone call to the customer be a sufficient action?

Is the customer simply refusing to pay or is non-payment due to an error or
misunderstanding?

Is credit or debt insurance available for a claim to be made?

Review supporting documentation to establish whether the correct goods were delivered?

Can we request return of goods using a retention of title clause?

Is it appropriate to use a debt collector’s services to chase a debt?

Is it appropriate to take legal action taking into account remedies available?

Do we need to make a claim to a liquidator if a customer is in liquidation?

Should we make a provision for a doubtful debt or write it off as irrecoverable?

Can we claim for any VAT suffered by using VAT bad debt relief?
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Chapter summary
 The benefit of offering credit to customers is the likely increase in sales. However, there are also
costs of lost interest and potential irrecoverable debts. The role of the credit control function is to
minimise these costs.
 The credit control function is involved in the ordering cycle in establishing customer credit status,
offering credit terms and throughout the collection cycle.
 Every business will have its own credit control policies, terms and conditions regarding how and
when payment is to be made by credit customers.
 When evaluating a customer's credit status, the concerns are that the customer will pay within
the stated credit terms and that the business will remain solvent.
 Credit assessment decisions need to be taken with the ethical principle of objectivity. This will
mean that decisions will be reached without bias, conflict of interest or any undue influence.
 When either a potential new customer requests credit, or an existing customer requests an
increase in credit limit, the credit controller will make use of internal and external information
about the customer, in order to determine whether or not the request should be granted.
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Keywords

Aged receivables analysis: An analysis of each individual receivable's balance split into
amounts that have been outstanding for particular periods of time

Briefing notes: Short notes that provide an outline for management on credit control issues
and actions taken

Credit limit: The maximum amount that should be outstanding on a customer's receivable
ledger account at any one point in time

Debt collection process: A process that outlines the steps an organisation will take to
encourage payment from customers

Doubtful debts: Debts where there is some doubt over whether the monies due will
eventually be received

Irrecoverable debts: Debts that will be written off

Overdue debt: A debt which has not been paid within the stated credit period

Reminder letter: A letter sent to a customer encouraging payment of an overdue debt

Statement: Analysis of the amount due by a customer and the transactions on their
account for the last period, which is periodically sent to the customer

Stop list: A list of customers to which goods should not be sold on credit
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Test your learning
1
If customer accounts in the receivables ledger are not kept accurately up to date, then this
can cause a number of problems.
Which of the following is not one of those problems?
A
B
C
D
2
Problem items may not be highlighted in the aged receivables listing.
Incorrect statements may be sent out to customers.
The correct goods may not be despatched to the customer.
Orders may be taken which exceed the customer's credit limit.
A customer of a business has an outstanding balance on its receivables ledger account of
£17,685 at 31 July. This balance is made up as follows:
£
22 May
Inv 093106
2,184
3 June
Inv 093182
3,785
21 June
Inv 093265
4,839
2 July
Credit note 04623
5 July
Inv 093321
3,146
20 July
Inv 093346
4,267
(536)
17,685
The customer's name is Fording Ltd and the company has a credit limit of £20,000.
Use the table below to complete the aged receivables analysis for this customer as at
31 July.
Customer
3
Total
Credit
limit
£
£
Current
<30 days
£
61–90
days
90 days
£
£
£
Which of the following might typically be highlighted by analysis of an aged receivables
listing?
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Slow payers
Settlement discounts taken
Exceeding a credit limit
Potential irrecoverable debts
Credit terms
Items in dispute
A
B
C
D
(i), (ii), (iv) and (v)
(iii), (iv), (v) and (vi)
(i), (iii), (iv) and (v)
(i), (iii), (iv) and (vi)
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Given below are extracts from an aged receivables analysis for a company at 30
September:
Kerry & Co
Marshall Ltd
Leyton Ltd
Total
Credit
limit
Current
<30 days
31–60
days
61–90
days
>90
days
£
£
£
£
£
£
5,389
8,000
4,999
16,378
15,000
16,378
5,377
10,000
1,854
390
1,757
1,766
Credit terms are that payment is due within 30 days of the invoice date.
For each customer, state what the aged receivables listing might indicate about that
customer and what, if any, action might be required.
Customer
Comment and action
Kerry & Co
Marshall Ltd
Leyton Ltd
5
What information available to the credit control team might indicate the existence of an
irrecoverable or doubtful debt?
6
A company has a policy of granting credit terms of 30 days from the invoice date. Once an
invoice is seven days overdue, a telephone call is made to the customer to enquire about
the debt. Once an invoice is 14 days overdue, a reminder letter is sent to the customer.
Once an invoice is 30 days overdue, the customer is placed on the stop list and a letter is
sent informing them of this.
Given below is an extract from the company's aged receivables listing at 30 June.
Total
Credit
limit
Current
<30 days
31–60
days
61–90
days
>90
days
£
£
£
£
£
£
Travis Ltd
4,678
5,000
4,678
Muse Ltd
3,557
5,000
2,669
Keane Ltd
6,248
8,000
5,145
888
1,103

The balance owing by Travis Ltd is made up of invoice number 467824 dated 15 May.

Invoice number 467899 to Muse Ltd for £2,669 was dated 2 June and invoice number
467831 for £888 was dated 23 May.

Invoice number 467781 to Keane Ltd for £1,103 was dated 22 April.
For each customer, determine what action, if any, is necessary according to the credit
collection policy and draft any letters that might be necessary to send to these
customers.
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CHAPTER 1 Managing the granting of credit
Activity 1: Comparing financial position
Business B has the weakest financial position.
Business B only has £200 cash available and needs to pay wages of £1,000 by the end of the
week. The trade receivable of £3,000 is already overdue and there must now be a risk that it is
not going to be settled in time so that the wages can be paid. This will cause liquidity problems
and Business B may have to look quickly for finance elsewhere, such as a bank loan or overdraft.
This will increase finance costs of Business B. If the wages remain unpaid at the end of the week
workers may withdraw their labour, which would make matters worse.
Business A is able to pay the rent liability of £1,500 out of cash available of £2,000, though the
trade receivable of £2,500 needs to be monitored to ensure the money is received as expected.
Business C is expecting a receipt of £5,000 next week from trade receivables. As the electricity bill
is due in two weeks this will allow the bill to be settled. However, as the electricity bill is for £1,200
and only £1,000 cash is available, Business C is dependent on the £5,000 being paid. If the
receipt is late, Business C will also need to seek alternative finance. The expected receipt of
£5,000 needs to be monitored carefully to ensure this is paid on time.
Activity 2: The ordering cycle stages
The ordering cycle involves the following:






Customer places order
Customer credit status established
Customer is offered credit
Goods are despatched
Good are delivered
Invoice is despatched
Activity 3: Settlement and cash discounts
Offering settlement discounts to customers
Advantages
Disadvantages
If cash from customers is received more quickly
this will improve liquidity and allow the business
to reinvest in stock and pay expenses
Can give a message to customers of being
desperate for sales
Reduces the risk of irrecoverable debts, as once
a debt has been settled any risk is eliminated
The financial cost of the discount itself
Customers may always expect discounts
Provides customer satisfaction and increases
goodwill
Activity 4: Identification of terms and conditions

Invoice must be paid in the month of issue of invoice
Invoice must be paid the month after the invoice date
Invoice must be paid within a month of the invoice date

Invoice must be paid net of any discount within a month of the invoice date
Activity 5: Policies and procedures
A credit control policy should contain procedures for dealing with customers who have exceeded
their credit limits, so that credit control staff know the actions to take to encourage late payers to
settle their accounts in a timely manner.
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Activity 6: Risks of granting credit
There are two main risks in granting credit to a customer:

The customer will exceed the stated credit period therefore depriving the seller of the use of
cash.

The customer may never pay at all – an irrevocable debt.
Activity 7: Sources of information
Source
Internal or external?
Reference obtained from a credit reference agency
External
Calculation of performance ratios from the customer's financial
statements
Internal
Conversations with a company's own sales team for feedback
on a customer's trading reputation
Internal
Entering a customer's name into an internet search engine
External
Visiting a customer's premises when viewing or demonstrating
some samples
Internal
Reviews in a trade publication
External
Analysis of an aged receivables report
Internal
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CHAPTER 2 Granting credit to customers
Activity 1: Bank reference reply
C `Do not grant credit
Activity 2: Interpreting references
The information in the bank reference looks positive. It is not as good as 'undoubted' but suggests
that the customer is probably okay and a reasonable risk.
The trade reference looks fairly positive in that XYZ Ltd offers 45-day payment terms and receives
prompt payment, which gives some confidence. However, the amount of credit they offer is only
£5,000 whereas Conrad Ltd has applied to you for credit of £8,000.
In conjunction with another trade reference and satisfactory other internal and external
information about Conrad Ltd, a decision may be taken to grant Conrad's credit request.
Activity 3: Gross profit margin and operating profit margin
%
Gross profit margin
20
Operating profit margin
10
Gross profit margin: (27,500/137,500)  100 = 20%
Operating profit margin: (13,750/137,500)  100 = 10%
Activity 4: Return on capital employed
%
Return on capital employed
15.6
Capital employed = Total equity + non-current liabilities (200,000 + 188,000 + 100,000 =
488,000)
Return on capital employed: (76,000/488,000)  100 = 15.6%
Activity 5: Current ratio
(a)
3,930/2,620 = 1.5:1 or 1.5
(b)
(3,930 – 1,530)/2,620 = 0.92:1 or 0.92
(c)
In part (a) the company's current assets exceed the current liabilities, therefore the
company has a degree of liquidity. For every £1 of current liabilities, there is £1.50 to cover
those obligations. In part (b) the current assets have dropped below the current liabilities,
due to money being spent out of the bank account. This could mean that the company
could struggle to pay debts as they fall, including suppliers, wages and salaries, overheads
and taxation. This would be a negative factor when completing a credit assessment on the
company.
Activity 6: Working capital cycle
(a)
Days
Inventory holding period
41
Trade receivables collection period
48
Trade payables payment period
47
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(b)
Inventory holding period: (77,000/686,000)  365 = 41 days
Trade receivables collection period: (130,000/980,000)  365 = 48 days
Trade payables payment period: (89,000/686,000)  365 = 47 days
Working capital cycle: (41 + 48 – 47) = 42 days
Activity 7: Cash flow indicators
Workings
Gearing ratio (%)
100,000/(200,000 + 188,000 + 100,000)
Interest cover
(45,000 + 6,000)/6,000
EBITDA-based interest cover
(45,000 + 6,000 + 12,000)/6,000
20.5%
8.5 times
10.5 times
Activity 8: Making a credit assessment decision
Bank reference
The bank reference is not the most positive that might have been given and indicates that
consideration should be given, in particular, to the liquidity and profitability of the company.
Trade references
Both trade references indicate that Haven Engineering Ltd is a slow payer; again, consideration
should be given to information in the financial statements to try to determine whether this is due
to liquidity problems, general inefficiency or a determined policy of the company. One trade
reference has confirmed that credit has been suspended at least once.
Financial statement analysis
20X6
20X7
20X8
35%
36%
36.5%
Operating profit margin
14.5%
15%
14.5%
Return on capital employed
12.6%
11.8%
10.5%
Net asset turnover
0.87
0.78
0.73
Current ratio
1.43:1
1.61:1
1.82:1
Quick ratio
0.98:1
1.08:1
1.20:1
Inventory holding period
52 days
58 days
61 days
Trade receivables collection period
74 days
76 days
75 days
Trade payables payment period
88 days
84 days
80 days
Gearing ratio
44%
44%
44%
Interest cover
4.8 times
4.8 times
4.0 times
Financial ratios:
Profitability
Gross profit margin
Liquidity
Gearing
From the analysis of the financial ratios, a number of points can be made about Haven
Engineering Ltd.
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Profitability
In terms of profitability, the gross profit margin has increased in each of the three years, although
operating profit margin is fairly constant.
Return on capital employed has fallen over the three years, due to the decrease in net asset
turnover. There has clearly been large investment in non-current assets over the period and, as
yet, this does not appear to have led to significantly increased revenue or profits.
Liquidity
The current ratio could be said to be rather low; however, it has been increasing in each of the
three years, and the quick ratio appears healthy and is also improving. The inventory holding
period is quite high and has increased by nine days over the period; consequently, there is
considerable capital tied up in the inventory holdings.
Perhaps of more concern are the receivables collection period and the payables period. The
receivables collection period has remained fairly constant but, at around 75 days, is a long time.
This might account for the length of time that Haven Engineering Ltd takes to pay its own
suppliers which, although improving, still stands at 80 days – which is 50 days longer than SC's
credit terms of 30 days.
Gearing
Although there have been small increases annually in the amount of long-term loans, the gearing
level has remained constant at 44%. Interest cover is also healthy at four times or over.
Recommendation
The evidence received from the bank reference, trade references and the financial statements
would indicate a problem with Haven Engineering regarding the period of time which they take
before paying their suppliers. The company appears to be profitable and despite the length of
time their own customers take to pay, there would not appear to be too serious a liquidity
problem. Therefore the late paying of suppliers could be a deliberate policy.
It is recommended that only £10,000 of credit is initially granted to Haven Engineering Ltd, with
an agreement that payment is to be strictly to 30 days of the invoice date. This period of credit
should perhaps be limited to a six-month period, during which the receipts from Haven
Engineering Ltd should be monitored closely. Haven Engineering Ltd should be made aware that
if payments are not received promptly, credit facilities will be withdrawn and only cash trading
will be available.
Activity 9: Scoring of financial ratios
20X6
20X5
ABC Ltd
Ratio
Rating
Ratio
Rating
Operating profit margin
7%
5
11%
10
Interest cover
1.4
–10
0.8
–20
Current ratio
1.7
10
1.4
0
70%
–20
55%
0
Gearing
Total credit rating
–15
–10




Reject credit application
Accept credit application
Both years' scores fall between 0 and –24 and meet the requirement to be a medium-risk
customer. On this basis, the credit application would be successful and accepted.
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Activity 10: Refusal of credit reasons
Reasons for not agreeing to trade on credit with a customer might include the following:








A non-committal or unsatisfactory bank reference
Poor trade references
Concerns about the validity of any trade references submitted
Adverse press comment about the potential customer
Poor credit agency report
Information from a member of the business's credit circle
Indications of business weakness from analysis of financial statements
Lack of historical financial statements available, due to being a recently started company
Activity 11: Signs of overtrading
The following factors can indicate that a business is overtrading.
(1)
Revenue increasing significantly in a short time period
(2)
Increase in inventory levels
(3)
Increases in trade receivables
(4)
Working on unsustainable low profit margins to attract trade
(5)
Reduction in cash balances
(6)
Continual use of short-term finance, for example overdrafts, to meet working capital
requirements
Activity 12: Identification of threats to objectivity


Self-interest
Self-review
Advocacy

Familiarity
Intimidation
The sister has a self-interest threat because she is paid according to the amount of sales she
makes. This means that she has an interest in her brother extending credit to as many customers
as possible so that her sales are high. There is a familiarity threat due to the relationship between
the two.
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CHAPTER 3 Legislation and credit control
Activity 1: Offeror and offeree
The customer is the offeror here, as they are offering to purchase the magazine. The newsagent is
the offeree, as they are the person to whom the offer is being made.
Activity 2: Invitation to treat or an offer?
This is merely an invitation to treat, as the priced-up umbrellas are there to encourage someone
to make an offer to purchase. If a potential customer was to pick up an umbrella, enter the shop
and indicate that they wish to purchase an umbrella then this would then be an 'offer'.
Activity 3: Pricing error
Jon cannot insist on purchasing the car at the lower price, as the price ticket is an invitation to
treat rather than an offer. Jon makes the offer to buy the car for £2,395 but this is rejected by the
salesman.
Activity 4: Changes to an offer
This would be a counter-offer and would be considered a new offer and a new contract. The
builder would not be expected to complete the additional work without the new contract terms
being accepted.
Activity 5: Essentials of a valid contract
A valid contract would not exist here as the element of value or consideration is missing. If the
work is carried out free of charge, then consideration would not have passed from the cyclist to
the shop owner. This is important: if the puncture was not prepared properly and the cyclist
missed an important appointment, then the cyclist would have difficulty in claiming for any loss
caused by poor workmanship.
Activity 6: Remedy for breach of contract (1)
The most appropriate remedy here would be 'action for the price' as this would enable the full
sales price of £100 to be recovered from the customer. An alternative here could be monetary
damages; however, this would only be able to recover compensation for any loss. In these
circumstances this would be the £60 the trader had previously paid for the goods.
Activity 7: Remedy for breach of contract (2)
As the cut trees cannot be restored or replaced, then possibly the fairest remedy to both parties
would be quantum meruit. Here the customer would pay the gardener for the work completed. As
three out of six trees have been cut, then possibly 50% of the original invoice may be agreed upon
between both parties.
Activity 8: Type of court


County Court
Magistrates' Court
High Court
Crown Court
As this amount is below £10,000 the claim will be heard in the County Court under the Small
Claims Track.
Activity 9: Method to receive payment
As the customer does not have an income and there is no other information on other interested
parties or assets, the most appropriate method of payment would be a warrant of execution. This
is where a bailiff seizes and sells a customer's effects – in this case, the two laptops.
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Activity 10: Bankruptcy an option?
Although the company may be experiencing serious financial difficulties, technically the
company itself would not be able to become bankrupt. Bankruptcy is only available for
individuals. The appropriate response would be to explain to the managing director that if the
company was unable to pay its debts, it would become insolvent.
Activity 11: Bankruptcy and insolvency
Bankruptcy
Insolvency
Where an individual is unable to pay debts
A receiver appointed to take control of assets
Process for companies that are unable to pay
their debts
Two options available: liquidation and
administration
Statement of affairs drawn up
Assets sold to pay debts
Liquidation – a liquidator appointed to
dissolve company and sell assets
Administration – an administrator appointed
to control company with a view to saving or
selling the company as a going concern
Activity 12: Late payment interest
The Late Payment of Commercial Debts (Interest) Act allows interest to be charged on gross
amounts for the time outstanding. The rate of interest is the Bank of England rate plus 8%.
£12,000 plus VAT £2,400 (£12,000  20%) = £14,400
£14,400  9% (1% + 8%) = £1,296
£1,296  (40/365 days) = £142.03
Activity 13: Customer information
Your colleague is incorrect and you would need to explain that the Data Protection Act prevents
companies from holding excess and non-relevant information on both hard-copy and soft-copy
media.
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CHAPTER 4 Methods of credit control
Activity 1: Settlement discount cost


18.4%
184.3%
1.8%
1.0%
1
365

= 18.4%
99 30 – 10
Activity 2: Settlement discount cost

2.0%
1.62%

16.2%
162.0%
2
365
×
= 16.2%
98 60 – 14
Activity 3: New receivables and annual finance cost
New receivables
£000
Annual finance cost
£000
A
200
20
B
200
40
C
400
20
D
400
40


New receivables balance = £2.4m  2/12 = £400,000
Annual finance cost for the new receivables balance of £400,000 at 10% = £40,000
Note: The question required you to calculate the total new receivables balance and the overall
finance cost. You were not required to calculate the increase in receivables nor the increase in
finance cost.
Activity 4: Factoring cost
£
Amount advanced by the factor
85,000
Factor's commission fee
2,000
Interest payable if receivables pay in 60 days
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699
£100,000  85% = £85,000
£100,000  2% = £2,000
£85,000  5%  60/365 = £699
Activity 5: Services provided by a factor

Insurance against irrecoverable debts
Administration of the receivables ledger
Provision of finance

Seizure of goods from customers who do not pay
Activity 6: A disadvantage of using a factor

Cost savings

Reaction of some customers
Advance of cash
Reduction in irrecoverable debts
Some customers may view the use of a factor by a business as a sign that the business is in
financial or cash flow difficulty and therefore may reconsider whether to carry on trading with
them.
Activity 7: Invoice discounting and factoring
Invoice discounting is simply the provision of finance to a business by the purchase of its invoices
at a discount. There is no involvement with the business's receivables ledger. Under a factoring
agreement, the factor will normally run the receivables ledger and collect the debts, as well as
providing finance in the form of an advance on a percentage of the face value of the receivables.
Activity 8: Debt insurance claim
The amount that can be claimed under debt insurance is £12,375.
The VAT element can be reclaimed from HMRC. £19,800/1.2  0.20 = £3,300.
The debt insurance will then be claimed on the net amount of £16,500 (£19,800 – £3,300)  75% =
£12,375.
£4,125 (£16,500 – £12,375) will be written off as an irrecoverable debt.
Activity 9: Type of insurance policy

Partial turnover policy
Whole turnover policy
Specific receivables' policy

Annual aggregate excess policy
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CHAPTER 5 Managing the supply of credit
Activity 1: Credit limits

Increasing goodwill with the customer
Ensuring the cancellation of any settlement discount offered
Loss of sale

Increasing the risk of non-payment of the amount due
The credit limit that is set for a credit customer will have been set by the credit controller as part
of the assessment of the risk of the customer. Therefore, if this credit limit is exceeded, it is
potentially increasing the risk that the business faces from these sales on credit.
Activity 2: Preparation of an aged receivables analysis
Bourne Ltd
Aged receivables analysis as at 31 October 20X4
Customer
name and ref
Total
amount
Current
<1 month
O/s
1–2
months
Overton
£10,000
£5,000 B101
£5,000 B96
Longparish
£6,600
£6,600 B111
Stockbridge
£5,775
£2,775 B102
Andover
£11,000
Greatley
£2,750
Total
£36,125
O/s
2–3
months
O/s
>3 months
£3,000 B23
£11,000 B72
£2,750 B34
£14,375
£5,000
£11,000
£5,750
Activity 3: Recording invoices correctly

The balance may be too high
The customer's credit limit may be exceeded

Settlement discounts may be lost
Further sales to the customer may be stopped
If an invoice is not properly recorded in the customer's receivables ledger account, then this may
mean that the next time that the customer places an order, the balance on the account is too low.
When the credit limit is checked to ensure that it is not exceeded by the new order value, the sale
might be authorised – even though the new order may, in fact, take the customer over the credit
limit.
Activity 4: Action to take
As the customer has current amounts due, but no 30 to 61 day amounts outstanding, it could be
assumed that they were a regular payer; therefore the £104 due from 61 to 90 days is likely being
queried. The best course of action would be to check the customer's correspondence file to
determine if this amount was indeed being queried – and also to check that the amount was, in
fact, due from this customer and that there were no errors in posting to the customer's account.
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Then a telephone call should be made to the customer to enquire why this overdue amount has
not been paid.
Activity 5: Irrecoverable and doubtful debts

An irrecoverable debt will not be received and an allowance is made
A doubtful debt may be received but it is written off
An irrecoverable debt may be received and an allowance is made

A doubtful debt may not be received and an allowance is made
An irrecoverable debt is one where it is almost certain that the money is not going to be received,
whereas a doubtful debt is one where there is some doubt over whether the money will be
received – but no certainty. The importance of the distinction between an irrecoverable and a
doubtful debt is in their respective accounting treatments. An irrecoverable debt is written off
from the financial statements, whereas an allowance is made for a doubtful debt.
Activity 6: Irrecoverable, doubtful debts and no action
No action
Allowance for
doubtful debt

D. Layed Ltd
Timley plc
Write off as
irrecoverable


Busted Ltd
D. Layed Ltd is within its credit limit; however, its outstanding balance is over 60 days old. This
may indicate this company is having financial difficulties and this debt may be doubtful as to
being settled.
Timley plc's balance is within its credit limit and is current. No action required at this stage.
Busted Ltd has exceeded its credit limit and a substantial amount of the balance outstanding is
now over 90 days. There is no current trading and it may be prudent to write off these amounts
as irrecoverable.
Activity 7: Telephone calls to customers
When making a telephone call to discuss an overdue debt with a customer, the following factors
are of particular importance:

Discussion with the customer should always be courteous.

The precise amount of the debt should be pointed out and the fact that it is overdue.

It should be established whether there is any query with regard to the debt and, if so, any
appropriate action should be agreed to resolve the query.

If there is no query, then a date for payment of the debt should be established.

All of this should be recorded for future reference.
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Activity 8: Aged receivables action plan
Possible actions
Castle Builders
As the amount is over 60 days, refer to the financial controller to
commence legal proceedings. The account should already be on stop
and an allowance made for a doubtful debt.
DD DIY Ltd
As part of the account is over 21 days overdue, a telephone call should
be made to chase the account. The £400 may be a dispute and
should be queried. An allowance for a doubtful debt can be made for
the £400.
AP Partners
£2,250 in total is overdue. This account should be on stop as £1,250 is
now over 30 days. A meeting needs to be arranged with the customer
to discuss the operation of the account.
Gatfield Ltd
This customer has one of the largest credit limits and is within that
limit. However, there are some amounts that are overdue and these
need to be chased. Normally, the account would be on stop but it may
be prudent to try to obtain payment before putting it on stop, to
retain the goodwill of the customer.
Krane Ltd
This customer has exceeded its credit limit and should be put on stop.
A check should be carried out to ensure all transactions have been
correctly recorded. The customer should be contacted to discuss the
situation.
Crane Co
Customer is within its credit limit and its balance is current. No action
is required at this stage.
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Test your learning:
answers
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Chapter 1 – Managing the granting of credit
1
D
(ii) and (iv)
2
D
Customer places order. (This is a main element of the ordering cycle.)
3
Net 14 days, 3% discount for payment within 7 days.
4
C
5
Credit circles are an external source of information, making use of knowledge from other
companies which may have customers in common.
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(i), (iv), (v)
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Chapter 2 – Granting credit to customers
1
C
Credit should be granted if further information is positive.
2
The information provided in the trade reference looks fairly positive in that SK Traders
offers monthly payment terms which are only occasionally overrun. However, the amount
of credit offered is only £8,000, whereas Caterham Ltd has applied to you for credit of
£15,000.
In conjunction with, perhaps, another trade reference and other internal and external
information about Caterham Ltd, this trade reference may give you some confidence in the
company.
3
4
Credit reference agencies can provide a variety of information about companies and
individuals, which may include the following:






Historical financial statements
Directors' details
Payment history
Details of any insolvency proceedings or bankruptcy orders
Bankers' opinions
Credit rating
C
Annual financial statements
5
20X9
20X8
Gross profit margin (%)
22.00
21.28
Operating profit margin (%)
12.00
11.70
Current ratio
0.54
0.66
Quick ratio
0.30
0.42
74.87
79.41
4.00
5.50
Trade payables payment period (days)
Interest cover (times)
6
ACORN ENTERPRISES
Finance Partner
Little Partners
Date
Dear Sir
Re: Request for credit facilities
Thank you for your enquiry regarding the provision of credit facilities to yourselves for
£8,000 of credit on 60-day terms. We have taken up your bank and trade references and
examined your latest set of financial statements.
Although your references are satisfactory we have some concerns about your profitability
and liquidity. Clearly, your overall profitability and liquidity position have improved since
20X7 but their levels are still lower than we would normally expect in order to grant a credit
facility.
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However, due to your bank and trade references, we are happy to offer you a credit facility
for six months, at the end of which time the movement on your account will be reviewed and
the position re-assessed. The credit limit that we can offer you initially would be £3,000 and
the payment terms are strictly 30 days from the invoice date.
Thank you for your interest in our company and we look forward to trading with you on the
basis set out above.
Yours faithfully
Jo Wilkie
Credit manager
7
Finance Director
Dawn Ltd
Date
Dear Sir
Re: Request for credit facilities
Thank you for your enquiry regarding the provision of credit facilities to yourselves for
£5,000 of credit on 30-day terms. We have taken up your trade references and examined
your latest set of financial statements.
Unfortunately, we are concerned about your levels of profitability, gearing and liquidity in
the most recent year, and also have some concerns about one of the trade references from
Johannesson Partners.
On balance, we are not in a position to grant your request for trade credit at the current
time, although we would, of course, be delighted to trade with you on a cash basis. If you do
not wish to trade on this basis and would like to enquire about credit terms in the future,
then we would be delighted to examine your current year's financial statements when they
are available.
Thank you for your interest shown in our business.
Yours faithfully
Credit controller
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Chapter 3 – Legislation and credit control
1
D
2
Alan cannot insist on purchasing the car for £3,000 as the advertisement is an invitation to
treat, not an offer. When Alan answers the advertisement, he is making an offer to
purchase the car for £3,000 – which can be accepted or rejected by the seller.
3
The business does not have to supply the goods at £15,000, as the additional term for
delivery the next day is a counter-offer, which rejects the original offer.
4
A
A fundamental term of a contract
5
B
Payment for part of the contract performed
6
C
Payment by a third party
7
A 'retention of title' clause is a clause included in contracts stating that the buyer does not
obtain ownership until payment is made.
8
The seven principles of good practice of the Data Protection Act with regards to personal
information are:







9
Agreement, consideration and intention to create legal relations
Lawfulness, fairness and transparency
Purpose limitation
Data minimisation
Accuracy
Storage limitation
Integrity and confidentiality (security)
Accountability
The eight rights for data subjects under the Data Protection Act are:








To be informed
Access
Rectification
Erasure
Restrict processing
Data portability
To object
Automated decision-making and profiling
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Chapter 4 – Methods of credit control
1
C
21.3%
Cost of discount =
2
365

 100
100 – 2 45 – 10
= 21.3%
2
C
Without recourse factoring does cover irrecoverable debts.
3
A
Advance of cash (this is a benefit, not a cost)
4
Any two of the following:
5

A whole turnover policy, where either the whole receivables ledger is covered but the
amount paid out for any irrecoverable debt is only, say, 80% of the claim; or 80% of
the receivables ledger is covered for their entire amount and any claim on these
would be paid in full

An annual aggregate excess policy, where irrecoverable debts are insured in total
above an agreed limit or excess

A specific receivables policy, where only specific receivables ledger customers are
insured for the irrecoverable debt risk

Key account policies, which name a selection of key customers on a policy taken out

Catastrophe insurance, sometimes referred to as 'supercat', where insurance is
taken out against non-payment by customers due to severe circumstances
£1,800 will be claimed under credit insurance and £200 written off as irrecoverable.
(£2,400/1.2  0.20) = £400 VAT. The net value of the invoice is £2,000 (£2,400 – £400).
90%  £2,000 = £1,800 to be claimed under credit insurance and £200 to be written off as
irrecoverable.
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Chapter 5 – Managing the supply of credit
1
C
The correct goods may not be despatched to the customer.
This is not a problem caused by inaccurate customer accounts in the receivables
ledger, because the goods will be despatched before the receivables ledger is written
up – so despatch will not be affected.
2
3
Customer
Total
£
Credit
limit
£
Current
<30 days
£
31–60
days
£
61–90
days
£
Fording Ltd
17,685
20,000
6,877
8,624
2,184
D
90 days
£
(i), (iii), (iv) and (vi)
4
Customer
5
Comment and action
Kerry & Co
The vast majority of this customer's debt is current, with a relatively
small amount outstanding in 61 to 90 days. This may indicate that there
was some dispute or error about this outstanding amount, which should
be investigated.
Marshall Ltd
This customer has exceeded its credit limit, which should be
investigated. However, the balance is all current and, if this is a valued
and reliable customer, it may be considered necessary to increase the
credit limit to facilitate higher levels of trading.
Leyton Ltd
This customer would appear to be a persistently late payer with
approximately one-third of its total debt spread over each month for the
last three months. The credit controller will need to re-affirm the credit
terms of 30 days with the customer and, possibly, offer some incentive
for earlier payment such as a settlement discount.
Information that might be available to the credit control team which might indicate an
irrecoverable or doubtful debt includes:








Evidence of long-outstanding debts from the aged receivables analysis
A one-off outstanding debt, when more recent debts have been cleared
Correspondence with receivables
Outstanding older debts and no current business with the customer
A sudden or unexpected change in payment patterns
Request for an extension of credit terms
Press comment
Information from the sales team
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6
Travis Ltd
This amount is 14 days overdue and therefore a reminder letter must be sent to the
customer.
Purchases ledger manager
Travis Ltd
30 June
Dear Sir
I do not appear to have received payment of the invoice detailed below. I trust that this is an
oversight and that you will arrange for immediate payment to be made. If you are
withholding payment for any reason, please contact me urgently and I will be pleased to
assist you.
Invoice No
Terms
Due date
Amount
£
467824
30 days
14 June
4,678.00
If you have already made payment, please advise me and accept my apology for having
troubled you.
Yours faithfully
Credit Controller
Muse Ltd
The invoice number 467831, for £888, is 7 days overdue and therefore a telephone call is
necessary to the purchases ledger manager explaining that the amount is overdue,
determining whether there is any query with the amount and agreeing a date for payment
of the overdue amount.
Keane Ltd
The invoice for £1,103 is over 2 months overdue and should be investigated. Furthermore,
the policy is that once an amount is 30 days overdue the customer is put on the stop list. It
would appear that this has not happened, as Keane Ltd has recent amounts (<30 days)
due totalling £5,145.
A letter would be sent to the financial controller of Keane Ltd.
Financial Controller
Keane Ltd
Date
Dear Sir
Further to our invoice detailed below, I do not appear to have received payment. I trust that
this is an oversight and that you will arrange for immediate payment to be made. If you are
withholding payment for any reason, please contact me urgently and I will be pleased to
assist you.
Invoice No
Terms
Due date
Amount
£
467781
30 days
22 May
1,103.00
I regret that, unless payment is received within the next seven days, I will have no alternative
but to stop any further sales on credit to you until the amount owing is cleared in full. If you
have already made payment, please advise me and accept my apology for having troubled
you.
Yours faithfully
Credit Controller
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Glossary of terms
It is useful to be familiar with interchangeable terminology, including IFRS and UK GAAP
(generally accepted accounting principles).
Below is a short list of the most important terms you are likely to use or come across, together
with their international and UK equivalents.
UK term
International term
Profit and loss account
Statement of profit or loss (or statement of
profit or loss and other comprehensive
income)
Turnover or Sales
Revenue or Sales Revenue
Operating profit
Profit from operations
Reducing balance depreciation
Diminishing balance depreciation
Depreciation/depreciation expense(s)
Depreciation charge(s)
Balance sheet
Statement of financial position
Fixed assets
Non-current assets
Net book value
Carrying amount
Tangible assets
Property, plant and equipment
Stocks
Inventories
Trade debtors or Debtors
Trade receivables
Prepayments
Other receivables
Debtors and prepayments
Trade and other receivables
Cash at bank and in hand
Cash and cash equivalents
Long-term liabilities
Non-current liabilities
Trade creditors or creditors
Trade payables
Accruals
Other payables
Creditors and accruals
Trade and other payables
Capital and reserves
Equity (limited companies)
Profit and loss balance
Retained earnings
Cash flow statement
Statement of cash flows
Accountants often have a tendency to use several phrases to describe the same thing! Some of
these are listed below:
Different terms for the same thing
Nominal ledger, main ledger or general ledger
Subsidiary ledgers, memorandum ledgers
Subsidiary (sales) ledger, sales ledger
Subsidiary (purchases) ledger, purchases ledger
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Bibliography
AAT Code of Professional Ethics (2017). Retrieved from: www.aat.org.uk
https://www.aat.org.uk/prod/s3fs-public/assets/AAT-Code-Professional-Ethics.pdf
Consumer Credit Act 2006. (2006). London, HMSO.
Consumer Rights Act 2015. (2015). London, TSO.
Data Protection Act 2018. (2018). London, TSO.
Late Payment of Commercial Debts (Interest) Act 1998. (1998). London, HMSO.
Trade Descriptions Act 1968. (1968). London, HMSO.
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Index
Debt collection process, 99, 107
Debt insurance, 82, 85
Definitions from the Act, 63
Doubtful debt, 96, 107
80/20 rule, 95
A
Acceptance, 50, 67
Accounts payable payment period, 40
Accounts receivable collection period, 40
Administration, 59, 67
Administration order, 59
Aged receivables analysis, 90, 107
Annual aggregate excess policy, 82, 85
Attachment of earnings order, 56
EBITDA, 27
Ethical principle of objectivity, 37
Express terms, 53, 67
External sources, 9
F
B
Factoring, 78, 85
Financial ratio analysis, 21
Bank reference, 18, 40
Bankruptcy, 57, 67
Breach of contract, 53, 67
Briefing notes, 101, 107
G
Gearing ratios, 26
Gross profit margin, 40
C
Capital employed, 23, 40
Cash discount, 73
Cash flow indicators, 27
Cash transaction, 4, 12
Collection cycle, 4, 5, 12
Communication of a credit assessment
decision, 34
Companies House, 20
Compensatory damages, 55
Conditions, 53, 67
Consideration, 67
Consumer Credit Act, 61
Consumer Rights Act, 60
Contract, 48, 67
Contract law, 48
Counter-offer, 50
Credit application form, 18, 40
Credit circles, 20, 40
Credit collection agencies, 78
Credit control function, 4, 12
Credit limit, 89, 90, 107
Credit reference agency, 20, 40
Credit scoring, 32
Credit transaction, 4, 12
Current ratio, 40
D
E
I
Implied terms, 53, 67
Insolvency, 57, 59, 67
Internal sources, 9
Inventory holding period, 40
Invitation to treat, 49, 67
Invoice discounting, 81, 85
Irrecoverable debts, 95, 96, 107
L
Late Payment of Commercial Debts
(Interest) Act, 61
Liquidation, 59, 67
Liquidity, 3, 12
Liquidity ratios, 23
M
Materiality, 95
N
Net asset turnover, 40
Net profit margin, 40
Data controller, 63, 67
Data Protection Act, 67
Data subject, 63, 67
Debt collection agencies, 78
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Small claims track, 55
Solicitors, 78
Statement, 99, 107
Statement of affairs, 58, 67
Statutory demand, 57, 68
Stop list, 101, 107
O
Objectivity, 40
Offer, 67
Offeree, 48, 67
Offeror, 48, 67
Operating cycle, 25
Ordering cycle, 4, 5, 12
Overdue debt, 100, 107
Overtrading, 31
T
Terms, 53, 68
Terms of credit, 6, 12
Trade Descriptions Act, 60
Trade reference, 19, 40
P
Personal information, 63, 67
Profitability ratios, 21
U
Unenforceable contract, 53
Unilateral contracts, 52, 68
Q
Quick ratio/acid test ratio, 40
V
R
Refusal of credit, 35
Remedies for breach of contract, 53
Reminder letter, 100, 107
Restitutionary damages, 55, 67
Retention of title clause, 59, 67
Return on capital employed (ROCE), 40
Revocation, 50
Revocation of an offer, 67
S
VAT, 98
Void contract, 53, 68
W
Warrant of execution, 56
Warranties, 53, 68
Whole turnover policy, 82, 85
With recourse factoring, 80, 85
Without recourse factoring, 80, 85
Working capital cycle, 25, 40
Settlement and cash discounts, 12
Settlement discounts, 6, 73
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